Sunday, September 28, 2008
John Gray in the Guardian
And more on the politico-cultural ramifications of the Paulson plan, an excellent essay by John Gray in the Guardian.
The Paulson Plan - a brave new world
So the final draft of the Paulson Plan is out. I find my copy at the New York Times (PDF).
It's obviously quite a lengthy document so I'll refrain from too much analysis until I've had chance to read it and catch up on some of the press response. My initial impression is that it has absorbed a lot of the different ideas that were milling around Congress, provided authority to the Treasury Secretary to implement all of them, but left it to his discretion on which of them actually do get implemented and how, along with a set of stated aims for the intervention and a substantial framework for oversight.
In other words, we need to wait and see how it is implemented. This is simply the legislative groundwork for the Paulson plan. We don't actually know what his plan is yet.
To shift focus from the economics of the package, the equity warrants are the most significant aspect. They are non-voting but this is still, in a sense, a mandate to nationalise the finance sector. Given the USA's ideological commitment to a free market capitalism where the Government watches from the wings, this is a substantial coup. A philosophical Rubicon has been crossed here.
This is a test too, not for free market capitalism which has already flunked, but for the sort of partnership of State and commerce that predominates in most of the rest of the world. The provisions against excessive executive compensation and the requirements to use the rights over the mortgages to effect a kind of Jubilee on foreclosure could be (maybe) the seeds of an ideology where the public sector acts as the political conscience of industry. We should welcome this warily.
It's obviously quite a lengthy document so I'll refrain from too much analysis until I've had chance to read it and catch up on some of the press response. My initial impression is that it has absorbed a lot of the different ideas that were milling around Congress, provided authority to the Treasury Secretary to implement all of them, but left it to his discretion on which of them actually do get implemented and how, along with a set of stated aims for the intervention and a substantial framework for oversight.
In other words, we need to wait and see how it is implemented. This is simply the legislative groundwork for the Paulson plan. We don't actually know what his plan is yet.
To shift focus from the economics of the package, the equity warrants are the most significant aspect. They are non-voting but this is still, in a sense, a mandate to nationalise the finance sector. Given the USA's ideological commitment to a free market capitalism where the Government watches from the wings, this is a substantial coup. A philosophical Rubicon has been crossed here.
This is a test too, not for free market capitalism which has already flunked, but for the sort of partnership of State and commerce that predominates in most of the rest of the world. The provisions against excessive executive compensation and the requirements to use the rights over the mortgages to effect a kind of Jubilee on foreclosure could be (maybe) the seeds of an ideology where the public sector acts as the political conscience of industry. We should welcome this warily.
Saturday, September 27, 2008
Unblocking the pipes
I've just seen this article on Bloomberg. It is actually rather reassuring.
I said before that the financial sector needs to contract substantially. To do this, it needs to deleverage and it seems increasingly likely that this is going to be hard because, once its trash mortgage portfolios are marked at a realistic price, large chunks of the sector are going to be insolvent. If you are insolvent, the value of your assets is not sufficient to meet your debts. The only way to resolve this impasse is through bankruptcy, passing the shortfall on to your creditors. This is what needs to happen to unwind the leverage and restore credit-worthiness to the system. It is good to see this is happening, and that the mortgage portfolios are being marked more realistically in the process.
It looks like the US legislature will be able to pass the Paulson plan in some form this weekend. Hopefully, it will be discretionary enough, and its managers will be astute enough, to use it to cushion this process of deleveraging rather than as a wholesale recapitalisation of the system. This latter action would only serve to transfer the gap between the value of assets and liabilities onto the public balance sheet rather than liquidating it. In other words, rather than allowing the banks' creditors to suffeer the consequences of their unwise investments, those consequences would be met by the US taxpayer.
I said before that the financial sector needs to contract substantially. To do this, it needs to deleverage and it seems increasingly likely that this is going to be hard because, once its trash mortgage portfolios are marked at a realistic price, large chunks of the sector are going to be insolvent. If you are insolvent, the value of your assets is not sufficient to meet your debts. The only way to resolve this impasse is through bankruptcy, passing the shortfall on to your creditors. This is what needs to happen to unwind the leverage and restore credit-worthiness to the system. It is good to see this is happening, and that the mortgage portfolios are being marked more realistically in the process.
It looks like the US legislature will be able to pass the Paulson plan in some form this weekend. Hopefully, it will be discretionary enough, and its managers will be astute enough, to use it to cushion this process of deleveraging rather than as a wholesale recapitalisation of the system. This latter action would only serve to transfer the gap between the value of assets and liabilities onto the public balance sheet rather than liquidating it. In other words, rather than allowing the banks' creditors to suffeer the consequences of their unwise investments, those consequences would be met by the US taxpayer.
Thursday, September 25, 2008
Consolidate your loans!
Unsurprisingly, this has been a rather tense and tough week in the financial sector. So this post may end up being pithily concise.
This article by David Leonhardt in the New York Times is one of the better analyses I've read.
Personally I'm wavering on the plan. The legislature have done a better than expected job in improving the bill, but I'm very doubtful that bringing these debts onto the public balance sheet is the right thing to do. It would be better, if the damage could be limited, to allow the banks to go bust and the debt to be written off. The plan that is being proposed is the equivalent of taking out a mortgage to pay off a credit card.
In the short term, this may be the only way to keep America solvent. But unless something is done to address the imbalance in what the US economy produces and what it consumes the root problem will only be postponed and eventually exacerbated. But I don't think there are leaders who have the courage to tell American consumers that they have to change their spending habits. So once the immediate crisis is averted I see things carrying on much as before... until the mortgage is foreclosed on as well.
In other words, this plan is only a good idea if someone can persuade Americans to give up their addiction to easy credit in the long term.
This article by David Leonhardt in the New York Times is one of the better analyses I've read.
Personally I'm wavering on the plan. The legislature have done a better than expected job in improving the bill, but I'm very doubtful that bringing these debts onto the public balance sheet is the right thing to do. It would be better, if the damage could be limited, to allow the banks to go bust and the debt to be written off. The plan that is being proposed is the equivalent of taking out a mortgage to pay off a credit card.
In the short term, this may be the only way to keep America solvent. But unless something is done to address the imbalance in what the US economy produces and what it consumes the root problem will only be postponed and eventually exacerbated. But I don't think there are leaders who have the courage to tell American consumers that they have to change their spending habits. So once the immediate crisis is averted I see things carrying on much as before... until the mortgage is foreclosed on as well.
In other words, this plan is only a good idea if someone can persuade Americans to give up their addiction to easy credit in the long term.
Monday, September 22, 2008
What is wrong with Western banking?
I said in an earlier post that the banking sector needed to shrink. And I promised an explanation of this. Well here it is.
According to the BEA's figures, in 1987, the contribution of the banking and insurance industries to national GDP was 5.79%. In 1997 it was 7.17%. In 2007 it was 8%. The financial sector is becoming a larger and larger part of the US economy.
This shouldn't be the case. The wider economic value of the banking sector (yes there is one!) is in the efficiency it creates in the allocation of capital. A working financial system channels money to those parts of the economy where it provides the greatest return on capital. Banking does this by facilitating direct investment; insurance does it by turning small, catastrophic risks into more likely but less impacting ones, making returns more predictable and thereby encouraging investment.
But the point is that finance doesn't produce capital; It allows it to be employed more efficiently. So if the financial sector were improving - rather than simply growing - you would expect it to become a smaller part of the economy over time rather than a larger one as it became a more efficient mechanism for deploying capital. Even in good times you would expect, if not absolute contraction, then certainly to see finance becoming a smaller and smaller proportion of overall GDP.
How has Western finance escaped this reckoning?
The first ploy is simply by leveraging 'beta'. The economy has been growing. By borrowing and investing you can make money as long as things keep going up. Things go up, you go up faster. The flipside is of course that you go down faster too. The simplicity of this ploy has largely been disguised by developing increasingly complex and opaque derivatives.
As an aside, contrary to reports in the press, derivatives are not intrinsically ruinous. They are by definition a zero sum game. If one counterparty loses money, it is only because someone else has made it. But by and large, they are a not much more than a punt on the markets. As such, they don't (intrinsically) really help to realise the macroeconomic efficiencies in capital allocation I mentioned before. And the more exotic and complex they are, the more opaque and illiquid they become, and arguably the less efficiently they allocate capital. And banks have devoted a lot of resources to developing, trading and hedging these things. This represents an abandonment of the core purpose of finance and a failure to create a macroeconomic return in capital efficiency.
Derivatives can, I believe, create liquidity and enhance capital allocation, but to do so they must be simple, transparent and not generate long-term counterparty risk. Creating ever more complex, bespoke, over-the-counter products rather than moving derivative markets onto exchanges represented a move in the wrong direction for the financial sector.
To return to the main thread: The other, more significant, engine for the imploded growth of the financial sector was charging what were effectively brokerage fees for the supply of credit to the consumerist West. It hardly needs to be said, but consumption on credit is a really bad idea. It is fundamental misallocation of capital. It produces no return at all. The mechanism is opaque but by now well studied. I won't bore you with yet another essay on the bursting of the property bubble.
But a consideration of how banking went wrong wil be vital once the dust has settled. It is clear that the cost of their catastrophic failure is society's loss confidence in Big Finance to manage the economy. It was of course always suspect to imagine that a regime run for the self-interest of employees and shareholders would, in the long run, prove more competent than a political establishment accountable to population at large. But in future, the banks will be subject to a lot more government regulation - and rightly so. What is vital is that government regulation is well thought out and intended to realise the value of a well functioning financial sector as well as just curbing the excesses. That means it needs to be about realising efficiencies, promoting transparency and liquidity, formed around principle rather than bureaucracy. This will be a difficult thing to accomplish.
According to the BEA's figures, in 1987, the contribution of the banking and insurance industries to national GDP was 5.79%. In 1997 it was 7.17%. In 2007 it was 8%. The financial sector is becoming a larger and larger part of the US economy.
This shouldn't be the case. The wider economic value of the banking sector (yes there is one!) is in the efficiency it creates in the allocation of capital. A working financial system channels money to those parts of the economy where it provides the greatest return on capital. Banking does this by facilitating direct investment; insurance does it by turning small, catastrophic risks into more likely but less impacting ones, making returns more predictable and thereby encouraging investment.
But the point is that finance doesn't produce capital; It allows it to be employed more efficiently. So if the financial sector were improving - rather than simply growing - you would expect it to become a smaller part of the economy over time rather than a larger one as it became a more efficient mechanism for deploying capital. Even in good times you would expect, if not absolute contraction, then certainly to see finance becoming a smaller and smaller proportion of overall GDP.
How has Western finance escaped this reckoning?
The first ploy is simply by leveraging 'beta'. The economy has been growing. By borrowing and investing you can make money as long as things keep going up. Things go up, you go up faster. The flipside is of course that you go down faster too. The simplicity of this ploy has largely been disguised by developing increasingly complex and opaque derivatives.
As an aside, contrary to reports in the press, derivatives are not intrinsically ruinous. They are by definition a zero sum game. If one counterparty loses money, it is only because someone else has made it. But by and large, they are a not much more than a punt on the markets. As such, they don't (intrinsically) really help to realise the macroeconomic efficiencies in capital allocation I mentioned before. And the more exotic and complex they are, the more opaque and illiquid they become, and arguably the less efficiently they allocate capital. And banks have devoted a lot of resources to developing, trading and hedging these things. This represents an abandonment of the core purpose of finance and a failure to create a macroeconomic return in capital efficiency.
Derivatives can, I believe, create liquidity and enhance capital allocation, but to do so they must be simple, transparent and not generate long-term counterparty risk. Creating ever more complex, bespoke, over-the-counter products rather than moving derivative markets onto exchanges represented a move in the wrong direction for the financial sector.
To return to the main thread: The other, more significant, engine for the imploded growth of the financial sector was charging what were effectively brokerage fees for the supply of credit to the consumerist West. It hardly needs to be said, but consumption on credit is a really bad idea. It is fundamental misallocation of capital. It produces no return at all. The mechanism is opaque but by now well studied. I won't bore you with yet another essay on the bursting of the property bubble.
But a consideration of how banking went wrong wil be vital once the dust has settled. It is clear that the cost of their catastrophic failure is society's loss confidence in Big Finance to manage the economy. It was of course always suspect to imagine that a regime run for the self-interest of employees and shareholders would, in the long run, prove more competent than a political establishment accountable to population at large. But in future, the banks will be subject to a lot more government regulation - and rightly so. What is vital is that government regulation is well thought out and intended to realise the value of a well functioning financial sector as well as just curbing the excesses. That means it needs to be about realising efficiencies, promoting transparency and liquidity, formed around principle rather than bureaucracy. This will be a difficult thing to accomplish.
Somewhat preoccupied
I have, I confess, been somewhat consumed with the Paulson Plan. It will become a little broader going forward... but this is the seismic event of the moment. The focus is likely to remain for a little longer.
Sunday, September 21, 2008
The Paulson Plan - why not equity?
Along with a growing multitude, Sebastian Mallaby, in an article in the Washington Post has mooted the idea of forcing banks to raise capital directly by issuing new equity. Aside from a need for political expediency, I don't think this one will fly.
It looks like Mr. Paulson has taken the view that the problem is not that the banks are under-capitalised. The problem his plan is trying to resolve is that the banks have assets on their books for which there is no market and hence no reliable market price. This bailout is not, or at least certainly shouldn't be, about getting more capital into the banking sector. It is about removing that uncertainty from bank balance sheets.
Simply providing more capital to the banks won't remove that uncertainty, however it is done. The assets of unknown price stay on their books. What is needed, as the Treasury has diagnosed it, is to quarantine the assets. I think this is probably right.
Moreover, it is not as if banks haven't tried to raise new equity capital. Certainly they have in the UK with a number of rights issue. Largely these have not been all that successful. There just isn't an appetite for banking equity at the moment.
That would leave the taxpayer to buy the new shares. And, indirectly then, those "toxic" securities are still on the public balance sheet because they are owned by banks in whom the Treasury now has an equity stake. It's hard to see the benefit apart from some dilution of the risk. But the cost of that is that those mortgage-backed securities are still creating large uncertainties about banks' balance sheets.
It looks like Mr. Paulson has taken the view that the problem is not that the banks are under-capitalised. The problem his plan is trying to resolve is that the banks have assets on their books for which there is no market and hence no reliable market price. This bailout is not, or at least certainly shouldn't be, about getting more capital into the banking sector. It is about removing that uncertainty from bank balance sheets.
Simply providing more capital to the banks won't remove that uncertainty, however it is done. The assets of unknown price stay on their books. What is needed, as the Treasury has diagnosed it, is to quarantine the assets. I think this is probably right.
Moreover, it is not as if banks haven't tried to raise new equity capital. Certainly they have in the UK with a number of rights issue. Largely these have not been all that successful. There just isn't an appetite for banking equity at the moment.
That would leave the taxpayer to buy the new shares. And, indirectly then, those "toxic" securities are still on the public balance sheet because they are owned by banks in whom the Treasury now has an equity stake. It's hard to see the benefit apart from some dilution of the risk. But the cost of that is that those mortgage-backed securities are still creating large uncertainties about banks' balance sheets.
The Paulson Plan - business as usual
So the response of a Democratic Congress to Paulson's bailout is in (New York Times and Washington Post).
Some things are sensible: the plan as originally drafted, clearly needed more oversight. And I think Mr. Paulson is wrong about executive pay. It's necessary to make the bill palatable to the public and any CEO who takes the golden parachute while his firm goes bust rather than participating is frankly going to have to get a new identity in Latin America.
Sadly, they didn't stop there and the thing risks becoming a political football. The push "for assistance for distressed homeowners" (NYT) is wrong-minded. Not because they shouldn't get assistance but that this does need to be a "clean bill". As a sidenote, I think 'focused' is probably a better word here. There's nothing clean about it. But the US Congress needs to curtail its usual dysfunction and get a bill passed. If it needs to be fixed later, so be it.
I'm doubtful this will happen though. Both parties are going to play to the gallery with this one.
Some things are sensible: the plan as originally drafted, clearly needed more oversight. And I think Mr. Paulson is wrong about executive pay. It's necessary to make the bill palatable to the public and any CEO who takes the golden parachute while his firm goes bust rather than participating is frankly going to have to get a new identity in Latin America.
Sadly, they didn't stop there and the thing risks becoming a political football. The push "for assistance for distressed homeowners" (NYT) is wrong-minded. Not because they shouldn't get assistance but that this does need to be a "clean bill". As a sidenote, I think 'focused' is probably a better word here. There's nothing clean about it. But the US Congress needs to curtail its usual dysfunction and get a bill passed. If it needs to be fixed later, so be it.
I'm doubtful this will happen though. Both parties are going to play to the gallery with this one.
Saturday, September 20, 2008
The Paulson Plan - First Take
The profound disquiet I felt on Friday when the news broke about a massive bailout of the financial sector by the US Government bordered on physical nausea. It seemed utterly corrupt. Undoubtedly it has become necessary. But the derivatives spivs have been allowed to profoundly endanger the economy with their hubris and greed. They have been allowed to get away with it. And the US taxpayer has had to take on debts of $700 billion to salvage the situation. It seems contrary to any sense of justice.
Having spent today keeping up with the details emerging from the cabal on Capitol Hill I am feeling slightly better about it. I would have preferred to see the banks recapitalised by a government purchase of equity - that would have ensured that the taxpayer got to see the eventual benefits of the rescue as well as the cost. But I suspect, pleasantly vindictive though it would be to dilute the capital of these reckless companies, this would not be all that pragmatic. So no partial nationalisation, richly deserved though it is.
In the first place, that equity will probably not hold its value. The banking sector needs to shrink substantially (more on this in a subsequent post). Secondly, the subprime instruments on their balance sheets have attained a rather totemic quality. To restore market confidence this "toxic waste" needs to be isolated.
So the US Government is left trying buy the stuff, sticking it in quarantine for a few years, and seeing how much money the taxpayer gets back. The problem is, nobody has a clue what it's worth. The Paulson gambit seems to be that it actually does have some value, but that it is impossible to realise it in the present market. That is, the problem is one of liquidity. The alternative is that the banks are still lying about, or at least inventing, the valuation to keep their balance sheets from falling apart. This doesn't strike me as unlikely. So it is quite a big, and desperate, punt by the Treasury.
The final judgment will have to depend on how much Paulson pays. The banks and the government are both over the barrel on this, but the government can probably afford to drive a hard bargain. This will take nerve; and even with nerve it won't be easy. The difficulties in valuing this complex, toxic instruments are precisely what has led to their illiquidity and the attendant market panic. But if Paulson is right and the problem is liquidity and he gets a good price, in the long run the taxpayer shouldn't be too much worse off. So it may turn out that this is not the heist of the century after all.
I'm not sure how hopeful to be that it turns out not to be though.
Having spent today keeping up with the details emerging from the cabal on Capitol Hill I am feeling slightly better about it. I would have preferred to see the banks recapitalised by a government purchase of equity - that would have ensured that the taxpayer got to see the eventual benefits of the rescue as well as the cost. But I suspect, pleasantly vindictive though it would be to dilute the capital of these reckless companies, this would not be all that pragmatic. So no partial nationalisation, richly deserved though it is.
In the first place, that equity will probably not hold its value. The banking sector needs to shrink substantially (more on this in a subsequent post). Secondly, the subprime instruments on their balance sheets have attained a rather totemic quality. To restore market confidence this "toxic waste" needs to be isolated.
So the US Government is left trying buy the stuff, sticking it in quarantine for a few years, and seeing how much money the taxpayer gets back. The problem is, nobody has a clue what it's worth. The Paulson gambit seems to be that it actually does have some value, but that it is impossible to realise it in the present market. That is, the problem is one of liquidity. The alternative is that the banks are still lying about, or at least inventing, the valuation to keep their balance sheets from falling apart. This doesn't strike me as unlikely. So it is quite a big, and desperate, punt by the Treasury.
The final judgment will have to depend on how much Paulson pays. The banks and the government are both over the barrel on this, but the government can probably afford to drive a hard bargain. This will take nerve; and even with nerve it won't be easy. The difficulties in valuing this complex, toxic instruments are precisely what has led to their illiquidity and the attendant market panic. But if Paulson is right and the problem is liquidity and he gets a good price, in the long run the taxpayer shouldn't be too much worse off. So it may turn out that this is not the heist of the century after all.
I'm not sure how hopeful to be that it turns out not to be though.
About this blog
So I'm starting a new blog. Why? The week just gone has seen a near meltdown of the Western financial apparatus. It is difficult to rationalise this as a freak anomaly. Fukuyama had it that the defeat of communism by Western capitalism marked the End of History; even 9/11, despite its enormous cultural impact, did not really call into question the West's ideological commitment to free market capitalism. The Economist asks: What next? That's what I want to know too.
I work on Wall Street. I am one of the villains of the piece. But this week has pricked my political conscience. I want something better than the corrupt poisonous hubris of... well my lot. If not to put into practice then at least to believe in.
I don't know what that is yet. This is a space for me to think about that.
I work on Wall Street. I am one of the villains of the piece. But this week has pricked my political conscience. I want something better than the corrupt poisonous hubris of... well my lot. If not to put into practice then at least to believe in.
I don't know what that is yet. This is a space for me to think about that.
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