Posts tagged ‘banks’

Bid Rigging for Municipal Asset Management

Rolling Stone Magazine has an good story on the conviction of a number of banks and brokers on charges of bid-rigging, specifically on contracts for short-to-medium term management of municipal bond cash accounts.  Apparently brokers were paid by certain banks to be given a look at all the other bids before they made their final bid.  The article focuses mainly on the ability of winning bidders not to bid any higher than necessary, though I would suppose there were also times when, given this peek, the winning bidder actually raised its bid higher than it might have to ace out other bidders.

This is classic government contracting fraud and it's great to see this being rooted out.  I am not wildly confident it is going to go away, but any prosecutorial attention is welcome.

But I am left with a few questions:

  • It seems that government contracting is more susceptible to this kind of manipulation.  Similar stories have existed for years in state highway contracting, and the municipal bond world has had accusations of kick-backs for years.  Is this a correct perception, or is the rate of fraud between public and private contracting the same but we just notice more with the government because the numbers are larger, the press coverage is greater, and the prosecutorial resources are more robust?
  • If government contracting of this sort is more susceptible to fraud, why, and how do we fix it?

The latter is not an academic question for me.  I run a company that privately operates public recreation areas.  I bid on and manage government contracts.  Frequently, a major argument used against the expansion of such privatization initiatives is that past government outsourcing and contracting efforts have been characterized by fraud and mismanagement.  The argument boils down to "the government has so many management problems that it can't be trusted with contracting for certain services so it needs to operate those services itself."

The only way to reconcile this view is to assume that private actors are more likely to act fraudulently and be dishonest than public employees.  If this were true, then the public would be safer if a public management process of questionable ability were applied towards public employees rather than outside private contractors, because those who were being managed would be less likely to take advantage.  And certainly there are plenty of folks with deep skepticism of private enterprise that believe this.

However, I would offer that only by adopting an asymmetric view of what constitutes fraud would we get to this conclusion.  Clearly, banks colluding to shave a few basis points off municipal asset returns is fraud.     As the author of the Rolling Stone piece puts it several times, the crime here is that the public did not get the best market rate.  So why is, say, elected officials colluding with public employees unions to artificially raise wages, benefits, and staffing levels above market rates not fraud as well?  In both cases insiders are manipulating the government's procurement and political processes to pay more than the market rates for certain services.

This is Bastiat's "seen and unseen" of the privatization debate.   Yes, the world is unfortunately littered with examples of government procurement fraud.  This is often cited as a reason for maintaining the status quo of continued government management of a diverse range of services.  But what we miss, what is unseen, is that these government services are often run with staffing levels, work rules, productivity expectations, and pay rates that would constitute a scandal if uncovered in a division of a corporation, particularly if the workers were spending a lot of money to make sure the manager handing them this largess was able to keep his job.

Yes, the public lost several basis points on its investments when it did not get the market rate of return from cheating bankers.  But it loses as much as 50% of every tax dollar sent to many state agencies because it does not get market rates (and practices) for state labor.

Not A Sign of Good Health

Swiss government bonds are trading at rates that imply a negative interest rate.  The German government is issuing bonds with interest rates of zero that are actually trading above face value.

This is really bad news.  Investing in these securities is effectively the equivalent of putting money in one's mattress -- it means that investors don't perceive any money-making uses for their money better than paying paying financially strong governments to keep it safe for a while.   I am far from an expert on banking regulations, but my first guess on this is that this is at least in part a function of bank capital requirements that effectively require banks to put a lot of cash into government securities no matter how bad the return.

Germany and Switzerland certainly are providing some value in creating a safe haven for capital, but I wonder if in the long-run this is anything but destructive, shifting wealth and investment out of the private economy and into investments with no return.

 

A Stupid Suggestion

A guest blogger on Megan McArdle's blog writes:

Here's my first such idea:

Abolish Mortgage-Backed Securities (and Offspring)

CDOs and credit default swaps don't kill financial systems, mortgages kill financial systems. There has been altogether too much opproprium directed at CDOs, credit default swaps and other structuring techniques that spread financial contagion, and not enough directed at the underlying collateral. The record seems to be, however, that Dick Pratt was correct when he called the mortgage "the neutron bomb of financial products."

This makes no sense.  I don't have time for a comprehensive argument, so here are a few bullet points:

  • His argument rests on the fact that mortgages have inherently hard-to-quantify risks.  I don't believe that, given how long the financial system worked just fine writing mortgages, but if this is really the case, shouldn't he be proposing to ban mortgages, not just mortgage-backed securities?
  • Holding the higher-quality tranches of an MBS simply cannot, by any mechanism I can fathom, be more risky than holding a lot of individual mortgages.  In fact, for a given bank, it should spread the risk geographically and to a larger number of mortgages.
  • The first actual problem with MBS's is that the default risks were under-estimated by those packaging the securities.  Basically, the top AAA tranches were too large (or too wide, I think the term is).  This is correctable, and likely already has been corrected (In fact it had more to do with the actions of the government-enforced credit rating oligopoly than with actions of bankers).
  • The second actual problem with MBS's is that the default risks were under-estimated by government regulators world-wide when in Basil II and the equivalent US law changes c. 1991, MBS's were given very preferential capital requirement treatment.  Basically, MBS were treated, for capital requirements, as if they were nearly as risk-free as US treasuries, providing incentives for banks to over-weight in them.
  • The largest problem was the reduction in credit requirements for mortgages.  Increasing LTV from 80% to 97% or 100% or even 100%+ hugely increased the risk of default, and no one really took that into account in MBS packaging or bank capital requirements.  Bank capital requirements for mortgages and MBS were set as if they were European style recourse loans with 80% LTV.  But the same regulations and requirements applied to MBS built on US-style non-recourse loans with 97% LTV, which is crazy.

Here is a better plan:

  1. Narrow the AAA tranches of MBS
  2. Fix bank capital requirements vis a vis mortgages and MBS
  3. Stop encouraging high loan to values on mortgages

Myth-Making By the Left on Europe Continues

The Left continues to push the myth that government "austerity"  (defined as still running a massive deficit but running a slightly smaller massive deficit) is somehow pushing Europe into a depression.  Well, this myth-making worked with Hoover, who is generally thought to have worsened the Depression through austerity despite the reality that he substantially increased government spending.

It is almost impossible to spot this mythical austerity beast in action in these European countries.  Sure, they talk about austerity, and deficit reduction, and spending increases, but if such talk were reality we would have a balanced budget in this country.  If one looks at actual government spending in European nations, its impossible to find a substantial decline.  Perhaps they are talking about tax increases, which I would oppose and have been occurring, but I doubt the Left is complaining about tax increases.

Seriously, I would post the chart showing the spending declines but I can't because I keep following links and have yet to find one.  I keep seeing quotes about "commitment" to austerity, but no actual evidence of such.

Let's take Britain.  Paul Krugman specifically lashed out at "austerity" programs there are undermining the British and European economy.  So, from this source, here is actual and budgeted British government spending by year, in billions of pounds:

2007: 544.0

2008: 575.7

2009: 621.5

2010:  660.6

2011:  683.4

2012:  703.4

2013: 722.2

Seriously, I will believe the so-called austerity when someone shows it to me.  And this is not even to mention the irresponsibility of demanding more deficit spending without even acknowledging the fact that whole countries already have so much debt they are teetering on the edge of bankruptcy.

Here is the European problem -- they are pouring hundreds of billions of Euro into bailing out failed banks and governments.  They are effectively taking massive amounts of available resources out of productive hands and pouring it into failed institutions.   Had they (or we) let these institutions crash four years ago, Europe would be seeing a recovery today.  The hundreds of billions of Euros used to keep banks on life support could have instead been used to mitigate the short term effects of bigger financial crash.

New Greek Bailout Announced

It is an open question how long this bailout will plug the dam.  I continue to maintain the position that Greece is going to have to be let out of the Euro. Pulling this Band-Aid off a millimeter at a time is delaying any possible recovery of the Greek economy, and really the European economy, indefinitely.  All to protect the solvency of a number of private banks (or perhaps more accurately, to protect the solvency of the counter-parties who wrote the CDO's on all that debt).

Anyway, the interesting part for me is that with this bailout, the total cumulative charity sent the Greek's way by other European countries now exceeds Greek GDP, by a lot.

Lesson We Keep Missing in the Financial Crisis: Bite the Bullet Now

Investors have a saying - your first loss is your best loss.  In other words, if you think an investment sucks, swallow your pride, take your lumps, and get out entirely now.

This is NOT how we have dealt with the financial crisis.  Through a series of bailouts, we have tried to keep failing financial institutions and countries on life support.   We have dragged out the reckoning on mortgages, so we still have not had a real clearing in the real estate market.  Worse, we have postponed, even entirely interrupted, financial accountability for those who made bad investments or took on too much debt.

Here is an interesting counter-example - Iceland, which basically went entirely bankrupt along with pretty much all their banks, is on the road to recovery.

The Bankrupt as Victims

One of the amazing aspects of our new post-modern outlook on personal responsibility and obligations is that folks who are profligate and take on too much debt are increasingly considered victims to which other people owe something (generally a bailout).

We see this no only among US mortgage holders but in Greece as well

Greek Prime Minister Lucas Papademos told lawmakers to back a deeply unpopular EU/IMF rescue in a vote on Sunday or condemn the country to a "vortex" of recession.

He spoke in a televised address to the nation, ahead of Sunday's vote on 3.3 billion euros ($4.35 billions) in wage, pension and job cuts as the price of a 130-billion-euro bailout from the European Union and International Monetary Fund.

The effort to ease Greece's huge debt burden has brought thousands into the streets in protest, and there were signs on Saturday of a small rebellion among lawmakers uneasy with the extent of the cuts.

So outsiders generously agree to pay for 130 billion Euros of past Greek spending if only the Greeks will cut their current spending by 3.3 billion Euros (at which spending level the country would still be running large deficits).  And people riot as if they have been gang-raped.  Incredible.

Let the Greeks go.  Of course, this is not actually about bailing out Greece, but about bailing out, indirectly, European banks that invested in Greek bonds.  The banks seem to run public policy in Europe, even more so than in the US.

Flash: European Finances Still Screwed Up

As I predicted, the various highly touted European debt and currency interventions last month did squat.  This is no surprise.  The basic plan currently is to have the ECB give essentially 0% loans to banks with the implied provision that they use the money to buy sovereign debt.  Eventually there are provisions for austerity, but I wrote that I don't think it's possible these will be effective.   It's a bit unclear where this magic money of the ECB is coming from - either they are printing money (which they refuse to own up to because the Germans fear money printing even more than Soviet tanks in the Fulda Gap) or there is some kind of leverage circle-jerk game going where the ECB is effectively leveraging deposits and a few scraps of funding to the moon.

At this point, short of some fiscal austerity which simply is not going to happen, I can't see how the answer is anything but printing and devaluation.  Either the ECB prints, spreading the cost of inflation to all counties on the Euro, or Greece/Spain/Italy exit the Euro and then print for themselves.

The exercise last month, as well as the months before that, are essentially mass hypnosis spectacles, engineered to try to get the markets to forget the underlying fundamentals.  And the amazing part is it sort of works, from two days to two weeks.  It reminds me of nothing so much as the final chapters of Atlas Shrugged where officials do crazy stuff to put off the reckoning even one more day.

Disclosure:  I have never, ever been successful at market timing investments or playing individual stocks, so I generally don't.  But the last few months I have had fun shorting European banks and financial assets on the happy-hypnosis news days and covering once everyone wakes up.  About the only time in my life I have made actual trading profits.

Thought problem:  I wish I understood the incentives facing European banks.  It seems like right now to be almost a reverse cartel, where the cartel holds tightly because there is a large punishment for cheating.  Specifically, any large bank that jumps off the merry-go-round described above likely starts the whole thing collapsing and does in its own balance sheet (along with everyone else's).  The problem is that every day they hang on, the stakes get higher and their balance sheets get stuffed with more of this crap.  Ironically, everyone would have been better getting off a year ago and taking the reckoning then, and certainly everyone would be better taking the hit now rather than later, but no one is willing to jump off.  One added element that makes the game interesting is that the first bank to jump off likely earns the ire of the central bankers, perhaps making that bank the one bank that is not bailed out when everything crashes.  It's a little like the bidding game where the highest bidder wins but the two highest bidders have to pay.  Anyone want to equate this with a defined economics game please do so in the comments.

Greek Government Essentially in State of Default

Nice tax refund you have coming .... we think we'll keep it

The [Greek] government has decided to stop tax returns and other obligation payments to enterprises, salary workers and pensioners as it sees the budget deficit soaring to over 10 percent of gross domestic product for 2011.

For all the supposed austerity, the budget situation is worse in Greece.  Germany and other countries will soon have to accept they have poured tens of billions of euros down a rathole, and that they will have to do what they should have done over a year ago - let Greece move out of the Euro.

Government workers and pensioners simply will not accept any cuts without rioting in the street.  And the banks will all go under with a default on government debt.  And no one will pay any more taxes.  And Germany is not going to keep funding a 10% of GDP deficit.  The only way out seems to be to print money (to pay the debt) and devalue the currency (to effectively reduce fixed pensions and salaries).  And the only way to do all that is outside of the Euro.  From an economic standpoint, the inflation approach is probably not the best, but it is the politically easiest to implement.

The Goldman Sachs Strategy

For a while now, a few authors have been quipping at Zero Hedge that the best investment strategy is to do the opposite of what Goldman Sachs is telling is retail customers.  The theory is that if Goldman tells the public to buy, it means that they are selling like crazy for their own account.

This seemed a bit cynical, but on Friday Zero Hedge observed that Goldman was telling its retail customers to buy European banks.  This advice seemed so crazy -- the European agreement last weekly explicitly did not contain anything to help banks in the near term with over-leveraged bets on shaky sovereign debt -- that for the fun of it I played along.  I shorted a couple hundred shares of EUFN, a US traded fund of European financial firms (took a bit of work to find the shares to borrow).

Made 6% in one day.  Thanks Goldman.

Testing My Understanding

Today, US markets are rallying strongly (Dow up 400 points or so at the moment) on news of coordinated central bank action that, that .... that what?  It looks to me like the US and European banks are merely building up liquidity in preparation for potential bank runs.  I would have considered this bad news, kind of like news we just went to DEFCON 2, but for some reason the market is rallying (though there was also an ADP report saying hiring was way up last month, which is certainly good news).

As I wrote yesterday, there only appear to be 3 solutions to the European debt crisis and this is not one of them.  If I am right and patterns hold, the markets will wake up in a day or two and say, "wait, there is still trillions of Euros of deteriorating sovereign debt sitting on bank balance sheets with 40:1 leverage ratios" and fall back.  I am thrilled that our economy shows signs of life and I know that corporate profits have been good, but I don't see any way a European debt crash won't have substantial negative effects on the US.   If I am wrong, the market will continue up, up and away and you should stop ever listening to me because I clearly don't understand squat.

Update:  Yesterday I posited that real solutions were going to be a combination of 1) default/haircut 2) Make someone else pay back the debt and 3) print money.  I have heard it argued this morning that today's announcement may be evidence of #2 (ie, US taxpayers will bail them out) or more likely #3 (since the ECB can't print money, but the Fed seems to be doing a lot of it, lets get the Fed to print more money for the Europeans .... I don't understand the mechanics well enough to pinpoint who would bear the inflationary consequences of this, but betting on the US to be the world's patsy is never a bad bet).

Rearranging the Deck Chairs in Europe

My new column is up at Forbes, and discusses solutions to the European debt crisis.  The problem is that there are really only three, and all are bad, so most solutions being proposed either attempt to disguise that they are bad or to disguise that they are not really doing anything.  An excerpt:

The default option will almost certainly wipe out a lot of powerful banking and financial interests as well as make it very hard for governments to keep spending money at their historic pace.  This will certainly have a bad effect on the larger economy, but we should be careful accepting forecasts of economic catastrophe as most of these come from these same powerful bankers and politicians.   Every group, down to the local dog catchers, argue that the world will suffer a calamity if their particular profession is harmed.  What we do know is that large banks and financial companies are even more intertwined with the political elite in Europe than they are in the US.   We can be pretty certain that, push come to shove, a solution that saves the banks and allows politicians to keep spending will be preferred.

That is why the Europeans will likely end up printing money to pay off the debt.  They almost certainly would be doing so already,were it not for Germany’s strong memories of its Weimar inflation years, when exactly this kind of money printing to pay down government debt led to hyperinflation and political instability.  But the appeal to politicians of shifting the costs from themselves and banks to the average consumer is simply too great to pass up.  If Germany can be convinced, then the European Central Bank will print Euros.  If Germany cannot be convinced, then countries will leave the Euro and print Lira and Drachma.

The Fed and Crony Capitalism

I will leave aside the issue of the recently revealed massive loans from the Fed to various banks.  It can be argued that being the provider of last resort for short-term liquidity in the banking system is a legal, even legitimate, role for the Fed.

But scan this list.  Here are some of the "banks" that got close near-interest-free money from the Fed

  • Verizon
  • Chrysler
  • Caterpillar
  • Harley-Davidson
  • Baxter International

I presume these loans were nominally for their financing arms, but what is the systematic-risk argument for backstopping manufacturer's credit operations?

When I was at McKinsey & Co, part of their relocation package was a $10,000 interest-free one year loan.  I had any number of new recruits say they did not need the loan.  I told them it was a business IQ test.  If you turned down the loan, we revoked your job offer (just kidding, of course).  I took the loan and dropped it into T-bills.

I wonder how many of these recipients really needed the money to survive or just got smart enough to claim dire need and took the money and just dropped it into something interest-bearing.

The True Cost of the Education Bubble

I hinted at it in my last post, but have addressed it in more depth in my column this week at Forbes.  A brief excerpt:

The theme from all these failures is distorted signals and corrupted communication.  People, no matter how savvy, cannot possibly research every nook and cranny of the economy before making an investment.  They make decisions, therefore, based on signals – prices, interest rates, perceived risks, and the profit history of other similar investments.  If these signals are artificially altered or corrupted, bad decisions that destroy wealth and growth will result.

Which brings me back to education.    I will tell you something almost every business owner knows:  We business owners may whine from time to time that banks won’t lend us money, but what really is in short support are great people.  Nothing has more long-term impact on an economy than amount and types of skills that are sought by future workers.  That is why everyone accepts as a truism that education is critical to economic health.

Unfortunately, there is good evidence that our education policies have already done long-term harm.   The signals we send to kids making their higher education plans have disconnected them from reality in a number of fundamental ways, causing them to make bad decisions for themselves and the broader economy.

Examples follow.  Read it all.

Two Lessons From the Last Five Years

I propose two lessons learned from the last five years:

  • There is no such thing as a risk-free return
  • There is no such thing as a perfect hedge
We are very, very close to seeing much of the financial system blow up because banks, particularly in Europe, have bought sovereign debt and leveraged it 30x to 40x.  The theory was that sovereign debt denominated in Euros, yen, or dollars was essentially risk-free.  Once that theory was proved to be bankrupt, financial institutions are now claiming all their sovereign debt is perfectly hedged.  I think we will find that untrue as well.  Hedging mechanisms don't work when the whole of the market is tanking -- its a similar problem to why earthquake insurance does not work.  No insurance company or counter-party can pay off when every single policy has a claim.

Bailed Out Banks Take On More Risk

I found this fascinating, if unsurprising, via Zero Hedge:

Ran Duchin and Denis Sosyura of the University of Michigan looked at the U.S.’ Capital Purchase Program. You may recall that this became the centerpiece of TARP once Hank Paulson decided that the money would be better spent directly buying into the banks as opposed to overpaying them for dodgy asset-backed bonds. (Mind you, other parts of TARP were spent overpaying for dodgy asset-backed bonds.)

The CPP lasted a little more than a year and invested $205 billion of taxpayer funds into various qualifying institutions. Not every bank that filled out the 2-page application was successful in gaining access. Others were approved but ultimately decided not to take the funds (probably because of the attached restrictions on pay and on paying out dividends.) In the end, 707 financial institutions received the funds.

Duchin and Sosyua looked at a sample of 529 public firms that were eligible for CPP and slotted them into categories based on whether they applied, whether they were approved and whether they ultimately took the money. They controlled for non-random selection (via measures of the banks’ financial condition, performance, size and crisis exposure); for changes in national and regional economic conditions; and finally for potential distinctions in credit demand.

They then viewed the banks’ CPP participation status in comparison with their subsequent risk appetite as demonstrated by (1) their consumer mortgage credit approvals or denials (viewed on a risk-profile controlled, application-by-application basis); (2) their participation in syndicated corporate loans for riskier credits and; (3) the risk profile of their investment asset portfolios. What did they find?

They found more risk, across the board.  There is a lot of detail, so I will leave it to you to go to the source for more, but Zero Hedge concludes:

The bail-out itself increased our chances of having the bail the banks out all over again. Moral hazard is no longer in the realm of the abstract

A few months ago I went through an unbelievable hassle refinancing my loan.  Based on current appraisals, my loan to value was less than 50%, but I still ended up coming to the table with more equity to reduce the new loan size.  I was staggered at how hard it was to close what should have been a dead-safe loan, given the LTV and my income and credit history.  The study actually has a finding related to that:

For mortgages the bailed-out banks increased their risk–

“after CPP capital infusions, program participants tilted their credit origination toward higher-risk loans by tightening credit standards for the relatively safer borrowers and slightly loosening them for riskier borrowers.”

–while at the same time ensuring that they didn’t trip off any alarms

“This pattern would be consistent with a strategy aimed at originating high-yield assets, while improving bank capitalization ratios, since the key capitalization ratios do not distinguish between prime and subprime mortgages.”

This is a fascinating sort of metric manipulation.  Having my loan go from 45% to 40% LTV does nothing, really, for the overall safety of the bank, but it improves their averages and makes them look safer, while all the way they are actually engaging in more risky behavior.

China Bubble Bursting

I don't have time today to link all the evidence, but the combination of crashing real estate markets and the Chinese government jamming liquidity into its banks tells me the China bubble is bursting as we speak.

This is an interesting test of the Austrian view of depressions vs. the Keynesian / Krugman / Thomas Friedman / MITI view of government-orchestrated prosperity.  If the latter are right, then China is doing more right to keep their economy going than any country in history and you should go invest all your money in Chinese real estate.

However, if one believes the Austrian model about government-enforced mis-allocation of capital and labor leading to bubbles and crashes; if one believes that the technocrat-beloved MITI was largely responsible for the Japanese lost decade; if one believes that the US govenrment through articially low interest rates and government-directed reductions in underwriting quality helped create the housing bubble -- then the mother of all crashes is looming in China.  Because no country has done more to reallocate resources and capital based on the whims of a few technocrats  and well-connected industrialists than has China.  After all, this is why Thomas Friedman loves China, that it does not rely on the judgement of millions of individuals to allocate capital, but instead on the finger pointing of a few at the top.

The Great Bailout

Peter Tchir via Zero Hedge

The AIG moment was the first time that the US threw any pretense of real capitalism out the window.  Bear Stearns at least was done by JPM with government help.  Fannie and Freddie were taken over, but they were always quasi government entities.  It was AIG that was truly special.  The government didn't even attempt to see if the banks had managed their exposures at all.  The government didn't even care if they had.  They panicked and saved the banks from their own folly - they didn't give capitalism a chance.  The US has never truly recovered from that.  The entire system looks to government support more and more.  Since AIG the Fed has been running at least one massive easing program or another constantly.  The government is lurching from spending program to spending program to keep the economy churning.

At the first signs of weakness we beg for the FED or ECB or the government to do something big and fast.  The European credit crisis seemed a final chance to put some capitalism back into capitalism.  To allow dumb decisions to pay the price for failure.  To reward the institutions that had properly navigated through the risks.  There was even a brief moment when it looked like Germany would do that - would force those who failed to pay the price and support those who had taken the best steps.  But now with Dexia bailed out and some super SIV on the way, it looks like we are once again heading down a path of not allowing failure - in fact we are once again rewarding failure and living beyond your means.  It isn't communism, but it certainly doesn't fit any classic definition of capitalism.

Taxpayers to Fund Bank of America Derivatives Losses?

Or maybe it is more correct to say that the taxpayer is being set up to keep BofA counter-parties whole. From Bloomberg, via Zero Hedge:

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation.

The Federal Reserve and Federal Deposit Insurance Corp. disagree over the transfers, which are being requested by counterparties, said the people, who asked to remain anonymous because they weren’t authorized to speak publicly. The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, while the FDIC, which would have to pay off depositors in the event of a bank failure, is objecting, said the people. The bank doesn’t believe regulatory approval is needed, said people with knowledge of its position.

Three years after taxpayers rescued some of the biggest U.S. lenders, regulators are grappling with how to protect FDIC- insured bank accounts from risks generated by investment-banking operations. Bank of America, which got a $45 billion bailout during the financial crisis, had $1.04 trillion in deposits as of midyear, ranking it second among U.S. firms.

“The concern is that there is always an enormous temptation to dump the losers on the insured institution,” said William Black, professor of economics and law at the University of Missouri-Kansas City and a former bank regulator. “We should have fairly tight restrictions on that.”

Obviously I am not a huge fan of bank regulation, but if the taxpayer is going to insure deposits, then the government has got to set and enforce capital restrictions on how those deposits are invested.  How many times do we have to learn this lesson?  The S&L crisis and the Texas bank collapse of the 1980's was caused by the exact same BS, investing taxpayer insured deposits in increasingly risky investments.

Normally, in a free economy, we expect lenders to enforce rules and discipline on those to whom they lend, just as fire insurers in the 19th century developed the first building codes and inspections to protect their themselves.  But if depositors are insured, they are not going to get worked up too much about BofA -- I am a depositor but I know the Feds will make me whole if the bank crashes.  Deposit insurance provides comfort to depositors and pays some dividends in heading off bank panics, but at the same time it relieves the bank of any accountability for how the deposits are invested unless the US government takes on that role.  Of all the BS regulations financial firms have to put up with, this is the one that should actually exist, and the implication in this article is that despite thousands of pages of new regulation, these basic protections still don't exist.  Sure, they exist in law, but there seems to be nothing to stop an agency from issuing exemptions, and this Administration has shown itself to love giving exemptions.

This reminds me a ton of the AIG bailout.  For some reason, there are a group of Wall Street companies (cough Goldman cough) that seem to have immense political power to protect investments in which they are a counter-party.  To this point, people have been expecting that the BofA holding company might soon fail, but the underlying banks would be fine and just sold off in pretty good shape.  Most of the trash is apparently at the holding company level.

The losers in all this are the counter-parties to these various derivatives, who would rather have a better set of assets to grab if the ship starts sinking.  Of course, they don't have any right to this -- they didn't make these original deals with the depository banks, they made them with Merrill Lynch and other trash BofA has bought.  But never-the-less, the Fed seems fired up to give these guys a special deal.  It reminds me of the Solyndra deal where the Administration allowed certain private parties to move ahead of the US Government on the creditor list, though at least in Solyndra's case these parties actually put some money into the pot for the privilege.  This seems to be a straight giveaway, and it is no surprise that the FDIC is apoplectic.

I Do Not Think That Word Means What You Think It Means

I am sympathetic to the OWS hatred for bailouts and crony capitalism, but struggle to understand how they intend to fix the consequences of the exercise of government power in the private world with yet more exercise of government power in the private world.

Apropos of very little, I found this bit from Matt Taibi funny (emphasis added)

1. Break up the monopolies. The so-called "Too Big to Fail" financial companies – now sometimes called by the more accurate term "Systemically Dangerous Institutions" – are a direct threat to national security. They are above the law and above market consequence, making them more dangerous and unaccountable than a thousand mafias combined. There are about 20 such firms in America, and they need to be dismantled

I am pretty sure that, by definition, a single industry cannot have 20 monopolies.

Though I share the same concern, my solution is to just let them fail.  Right now, the cost of capital for these large companies is lower than the cost of capital for smaller companies because, even though many of them have far worse balance sheets than smaller banks, investors feel they have too big to fail protection.  Let a few fail and have the cost of capital shoot up for larger companies and you can be pretty damn sure they market itself will break up these companies.

In some ways it reminds me of the market premium given in the 1960's to multi-industry conglomerates like ITT.  When the capital markets made their cost of capital low, everyone tried to copy their conglomerate strategies.  When these strategies started failing and companies like RJ Reynolds found their diversification into shipping and shower curtains was a business disaster, capital dried up for these Frankenstein monsters and most of them were broken up.  All without a hint of government intervention, either to save them or kill them.

Its telling that no one on the Left or with OWS who gives this advice for financial institutions takes their own advice with, say, auto companies.  GM should have failed and likely been broken up as well.

Google and Government

This is a pretty interesting interview with Eric Schmidt of Google.  I am running out the door and don't have time to excerpt it, but in short, Schmidt is quite critical of the ability of government to intelligently regulate technology.

His solution is telling.  There is nothing here about reducing the power and scope of government, despite his clear and concise description of its consistent structural failures.  His solution:  more power for my guys.  That way, when Washington plays its game of sacrificing the less connected in favor of the well connected, we will do OK.

I am working on this concept for my next Forbes column vis a vis the Occupy Wall Street movement.  The OWS folks seem incoherent to us, because, in short, they complain about people having unfair power over them and then their solution is ... to give other people more power.   I have reconciled this in my mind with a cold war analogy.  Everyone accepts the arms race as a fact, and so the only way to survive is to have more nukes than the other guy.  The only way to deal with power, is to get more power for my side.

Frankly, its time for disarmament.  As a retailer, I get irritated with credit card processors, but I understood when Congress was considering regulation of interchange fees that giving the Feds the power to set credit card terms, rather than the banks, was not going to make things any easier, just shift the costs from more to less favored constituencies (and consumers are always the least favored constituency).

More later as I sort this out in my head.

Definition of Insanity

I am amazed that the US equity market can fall for the same load of BS over and over again

Stocks finished with strong gains amid optimism about plans to recapitalize euro-zone banks.

Two thoughts

  1. There is simply no source of money (and will) anywhere large enough to fill in the European debt hole.  Heck, there isn't enough money and will to fix Greece, and that is a small percentage of the problem
  2. Even if the current hole could nominally be recapitalized, it would be virtually meaningless because the no one in Europe is fessing up to anywhere near the total extent of the problem.

Countries are going to start to default in Europe, and I don't see any way around it.  The Euro isn't toast but its going to have a lot fewer members in 3 years.  And speaking of bad news, I don't see any way to avoid a massive Chinese bubble burst in the next 3 years either.

Federal Financing Bank?

Bruce Krasting at Zero Hedge has been on the case of the Federal Financing Bank.  I am still unclear if the agency is actually providing the cash or just the guarantee, but it was the one rolling out the Solyndra loan (under DOE auspices, I suppose).

In July, it was still sending cash of some sort to Solyndra - it may be that this was just a drawdown of money under its original loan commitment, or it may be new money.  A couple of things you can see are:

  • A heck of a lot of money was still going out the door to solar programs, likely with no oversight
  • Ford, the supposedly bailout-free company, sure seems to be gobbling up a lot of government guaranteed loans for something.
  • We were lending to Solyndra at 0.89% interest.
All told, a whopping 3/4 of a billion dollars of government guaranteed loans to private companies went out the door in July alone.
Other observations from the report:  The report is hard to read, as it is hard to correlate the new financing activity to changes in the balance sheet.  But there is just a ton of loan activity to rural electric companies.  Wasn't rural electrification an issue in the 1930's?  Isn't it time to let rural electric companies stand on their own two feet and get their own money from the capital markets?
There is also a lot of activity issuing HOPE for Homeowners money - it looks like the government is lending (to banks?) at 0.01% interest.  What is the difference between a 0.01% thirty year loan and a gift?

When Investors Have Police Forces

I have argued many times that private investors, over the long haul, will make better investment choices than the government, in part because they have better incentives and information to guide their decision-making.  The straw-man argument against this is to point out anecdotes of failed private investments.  Heck, I can do that.  Pets.com famously blew through $300 million of private capital with a corporate strategy that never made much sense to people.

The Pets.com investors were chagrined, and probably learned a lesson from their mistake.  Certainly most of us thought the blame, if blame existed, for the debacle rested on the investors for pouring money into a bad proposition.  Certainly no one accused the management of fraud -- I am sure they were diligently, honestly trying to make the company a success, even if they were misguided as to where that success lay.

As it turned out, everyone, not just the Pets.com investors, learned from the mistake.  The failure was an important driver in an industry-wide rethink as to what a successful Internet business model might look like.  This benefit only came because people were willing to acknowledge not just that the Pets.com investment was flawed, but that it represented a systematic mistake that was being made vis a vis Internet startup investments.

Now, consider solar manufacturer Solyndra.  It failed this week, likely taking with it most of $535 million in taxpayer money that the Obama Administration was so eager to give them that it short-cutted its internal processes to fork over the cash more quickly.

Many of us on the outside would love to see the government rethink such investments in a systematic way, and reconsider if it is even possible for the government to make such investments, and in particular whether "green jobs" investments make any sense at all.

But the likelihood of that kind of introspection happening in the public world is about zero, and my bet is that Obama is going to propose more of the same tonight in his speech.

In fact, the Department of Energy (the source of the loan) and the FBI have today sent armed agents into Solyndra looking for evidence of fraud.   While Zero Hedge argues that fraud would be bad for Obama, in fact I think it would probably be the best possible outcome and one he is hoping for.  If he can say, "wow, you and I both got tricked here by some evil folks we are going to put in jail" it deflects attention from the fact that he put a half billion dollars of taxpayer money into a business plan that never made a lick of sense.

Another me-too solar manufacturer with a factory in California of all places was never going to compete in a global commodity market.  This company's plan was always to sell dollars for 50 cents and to make it up on volume.  I don't see how any investor thought this was going to work.  My guess is that the private investors didn't know much about solar and invested because it had a certain hip-ness to it, or less charitably, they knew it never made sense but hoped that Uncle Sam, once it was already in for a half billion, would keep more money flowing or perhaps agree to buy out their production at above market prices.

There may have indeed been fraud, but as in the case of Pets.com, it is perfectly possible no real internal fraud existed and they ran through a ton of money against a stupid business plan that should never have been funded.  Obama would greatly prefer to call it fraud rather than his own failure of judgement.  As an aside, Fannie and Freddie are pursuing exactly the same course in suing banks, arguing that they were defrauded by the banks in buying mortgages, a fairly laughable proposition in the great scheme of things when one considers Fannie and Freddie were at the forefront of the industry in driving down lending standards and promoting the expansion of the mortgage market.

Financial vs. Operating Investors

Kevin Drum argues that Conservatives have vastly over-estimated the effects of capital gains tax changes on investment.

I can't agree with parts of the article that seem to argue that all taxes have limited effects on behavior (this is easily disproved, just look at what the tax code does for preferences of issuing debt vs. equity, or even look at the mortgage market).  But I have always suspected that the political focus on the capital gains tax represents another piece of evidence that financial players (Wall Street, banks) dominate much of economic regulation.

All things being equal, a low capital gains tax is fine.  If I sell some stock, its nice to pay a lower tax on the profits, particularly since at some level those profits have already been taxed once at the corporate level.  Financial players who buy and sell securities live and die by the capital gains tax, and I suppose for businesses there is some advantage in that it perhaps reduces the cost of debt and equity.

But as a business person with my own company, that capital gains tax is largely irrelevant to my investment decisions.   That is because all my investments are made to generate cash flow, and thus the regular tax rate is the ordinary income tax rate.  Perhaps one time in my life, if ever, the capital gains tax will be hugely relevant when I sell my business, but that is at some time in the future so nebulous that it does not affect my behavior.   Other than the double taxation argument, I have never understood why those who take their investment gains in asset value appreciation rather than in income should get different tax treatments.