"Too Big To Fail" To Fail?

Over the weekend, the White House either released a new part of their regulatory plan or got the AP to bite at its larger intent - that they seek the end of "too big to fail" institutions that threaten to take down the entire economy.

They are the biggest of the big — the Citigroups, the Goldman Sachses, the AIGs and other financial behemoths. The Obama administration doesn't want so many around anymore.

Financial regulations proposed by the president would result in leaner and simpler institutions that don't carry the weight of the system on their marble columns [...]

So far, however, congressional debate has centered on the administration's plan to put the Federal Reserve in charge of these "systemically significant" companies. Less attention has focused on the potential effect on the institutions and the financial system's hierarchy.

Under the administration's proposal, companies such as Citi, Goldman Sachs and others in a broad top tier engaged in complex transactions would face stricter scrutiny and have to hold more assets and more cash as cushions against a downturn.

They also would have to anticipate their own demise, drafting detailed descriptions of how they could be dismantled quickly without causing damaging repercussions. Think of it as planning their own funerals — and burials.

Obama's plan, in short, aims to make it far less appealing to be so big. That was the middle ground the administration sought, a step short of an outright ban on systemically risky companies.

This sounds like a return to the behavioral economics mode that Obama wanted to push going into the White House - in effect, he wants to nudge big institutions from getting so large and interconnected that they must be kept on life support. The rules described here aren't entirely specific, but it sounds like the biggest companies will need to lower their leverage and increase their capital requirements as they grow.

Some believe that eliminating "too big to fail" is impractical. And those beliefs should be taken seriously. But even those critics believe that the way to do it is through capital requirements and leverage. So this is pretty much on the right track.

Now, if the White House takes this advice from the President of the New York Fed, we'd have something.

The Federal Reserve should break with past policy and try to identify and deflate asset bubbles before they can damage the U.S. economy, New York Federal Reserve President William C. Dudley said.

While interest-rate policy may not be the appropriate tool for popping bubbles, Fed officials have "other instruments in their toolbox," Dudley notes in the text of a speech scheduled for July 26 at the Bank for International Settlements in Basel, Switzerland. The New York Fed released his remarks yesterday.

The Fed's view has been that bubbles can be identified only in hindsight, and that all the central bank can do is prepare to clean up after they burst. The current crisis shows that policy is mistaken, Dudley said.

"Asset bubbles may not be that hard to identify," he said. "This crisis has demonstrated that the cost of waiting to clean up asset bubbles after they burst can be very high."

Dudley did not specify what tools the Fed should use. Analysts have suggested that central bankers might raise reserve requirements or amp up restrictions on margin lending.

Simon Johnson links approvingly but wonders if the Fed can actually meet this task.

Of course, if the Fed can’t get better at spotting bubbles, the implication is that no one can. Which means that “macroprudential regulator” is just a slogan – a nice piece of what Lenin liked to call “agitprop”.

And if macroprudentially regulating is an illusion, what does that imply? There will be bubbles and there will be busts. Next time, however, will there be financial institutions (banks, insurance companies, asset managers, you name it) who are – or are perceived to be – “too big to fail”?

You cannot stop the tide and you cannot prevent financial crises. But you can limit the cost of those crises if your biggest players are small enough to fail.

It really all goes back to that. Hopefully the Administration is on the right track.

Why Don't You Just Make The Check Blank

It really has been comical to see the leaks of the stress tests trickle out, first with full confidence in the strength of the banks, then less, then less, and now a situation where Bank of America needs $34 billion dollars. Their total market capitalization right now is only $70 billion. The word "insolvent" comes to mind.

The government has told Bank of America it needs $33.9 billion in capital to withstand any worsening of the economic downturn, according to an executive at the bank.

If the bank is unable to raise the capital cushion by selling assets or stock, it would have to rely on the government, which has provided $45 billion in capital through the Troubled Asset Relief Program.

It could satisfy regulators’ demands simply by converting non-voting preferred shares it gave the government in return for the capital, into common stock.

But that would make the government one of the bank’s largest shareholders.

The company has certain assets they could sell, if anyone's in the market for a bank right now. But the most likely scenario makes the US government a near-controlling interest in Bank of America. Citigroup, which already has converted government preferred shares to common stock, needs an additional $10 billion or so, according to this report. It's not all that reassuring to hear BofA spokesmen claim that they'll be able to make $30 billion a year in income once the recession clears, which I think is more than Exxon.

Unfortunately, this is a fight that's already lost, Obama dinners with Paul Krugman aside. The banks will not be nationalized, and most likely they will be propped up until the crisis lifts. Geithner and Summers have their reasons for this, and the Administration doesn't see Congress playing along with anything that might damage the banksters too heavily (see cramdown) or allocating the money that would be needed for a restructuring. Mike Lux offers a couple post-TARP solutions that I think make sense:

The first is to really invest in long-term organizing and institutional building on the finance issue. While it is disappointing that Obama hasn't used this economic crisis and the populist anger it invoked to more fundamentally change the system that brought us to this pass, it's not like finance issues are going away or recede in importance in years to come. Now is the time to build institutions with the grassroots, political, and intellectual firepower to battle the banks in the years to come. We clearly have a stable of economists and business people who get what is going on, including George Soros, Joseph Stiglitz, Paul Krugman, Dean Baker, Rob Johnson, Simon Johnson, Leo Hindery, and others. What we need is long term institutional political power to build the constituency that will fight this fight effectively.

Just as importantly, we need to work constructively with the Obama administration to be prepared with a plan B if what they are doing begins to show significant weaknesses. If, as we restructuring advocates fear, the Geithner/Summers plan does not work to rebuild the economy, and/or the plan is gamed by the big banks to create other AIG bonus style scandals, Obama will be forced to turn to a plan B. If that happens, as I wrote a few weeks ago, progressives should avoid going into I-told-you-so mode, and instead be ready with a strong progressive plan that they can push with the administration. The economic thinkers listed above ought to be working together right now to come up with a strong plan B option. If we can keep a constructive dialogue going with the White House, and mobilize our friends in Congress and in the media, such a plan has a chance of being adopted.

I'll begin this new constructive arrangement by saying that I really like one aspect of the government's new plan - the idea that banks who want to return TARP money must cut themselves off from all the rest of the government largesse they receive to keep them afloat.

Banks that want to return Troubled Asset Relief Program funds will have to demonstrate their ability to wean themselves off another major federal program, according to senior government officials, making it less attractive for some banks to return the money.

The other program, a guarantee of debt issuance offered by the Federal Deposit Insurance Corp., allows firms to borrow money relatively inexpensively. Banks have $332.5 billion of debt outstanding under this program, which began last fall.

If you don't need assistance, prove it. Either you stay on the government dole or leap off. And either way, the government will regulate you in the future so you can't borrow using 30-1 leverage and take up half the national economy. If this is the result, I can basically live with it. But of course, this only applies to those few banks healthy enough to weather the storm. The Bank of Americas of the world? We're going to need a Plan B for them.

Stress'd

Arianna Huffington delivers the verdict on the Administration's stress tests before they come out later this week, and it's hard to argue with her:

For starters, why the holdup in releasing the results? It's been ten days since the Treasury Department and the Fed let the banks in on the preliminary results of the tests. So how come the public -- you know, the ones who keep bailing out the banks -- are still, ten days later, in the dark?

The reason is, the banks are using this time to negotiate how much information about their portfolios the hoi polloi will be privy to, and are trying to get the government to reconsider its analyses (which are already iffy, since they are based on the banks' own estimates and on assumptions about the economy - including unemployment rates, and cumulative real estate and credit card losses -- that are hardly stress-inducing). This is the equivalent of a teacher giving a student a look at his grades and allowing the student to try to cut a better deal before report cards are sent home to mom and dad [...]

And then there is the trouble with the assumptions at the heart of the stress tests. As Nouriel Roubini put it: "These are not stress tests but rather fudge tests... The results of the stress tests -- even before they are published -- are not worth the paper they are written on."

Nassim Taleb agreed: "This stress test is the equivalent of testing the Brooklyn Bridge by running a single heavy truck on it."

The ongoing horse-trading between the banks and the government has only exacerbated the mistrust, creating what the New York Times' Andrew Ross Sorkin, appearing on Charlie Rose, described as a lose-lose:

"Either you are going to be very realistic, perhaps even too realistic for many people, and you're going to suggest that some of these banks really are insolvent...or you're going to decide that the entire process is a whitewash and you're going to have no confidence in the test to begin with."

The fact that the releases, in absence of official information, have moved from all the banks being well-capitalized to now 10 of them requiring more funding simply destroys whatever positive spin will be overlaid on the eventual release. What some call "requires more capitalization" I call "insolvent," and needing a restructuring of their debt to flush out the toxic waste. Yet that option, as Arianna notes, has been taken off the table. Administration leaders insist that all capital requirements can be met through the private sector and no additional interventions from the government will be necessary. That may be the case on the surface, but considering that multiple government lending programs currently exist that save banks billions of dollars, it doesn't really mean anything. In fact, the web of government largesse outside of direct capital infusions going to the banks suggests a far too cozy relationship between the banksters and the policymakers:

The Federal Reserve Bank of New York shaped Washington's response to the financial crisis late last year, which buoyed Goldman Sachs Group Inc. and other Wall Street firms. Goldman received speedy approval to become a bank holding company in September and a $10 billion capital injection soon after.

During that time, the New York Fed's chairman, Stephen Friedman, sat on Goldman's board and had a large holding in Goldman stock, which because of Goldman's new status as a bank holding company was a violation of Federal Reserve policy.

The New York Fed asked for a waiver, which, after about 2½ months, the Fed granted. While it was weighing the request, Mr. Friedman bought 37,300 more Goldman shares in December. They've since risen $1.7 million in value.

Mr. Friedman also was overseeing the search for a new president of the New York Fed, an officer who has a critical role in setting monetary policy at the Federal Reserve. The choice was a former Goldman executive.

Of course, only the bankers understand the economy, so we should just shut up and let them raid the Treasury.

As Simon Johnson notes, this adds up to a major credibility problem for the Treasury Department.

In any case, this is a serious problem for Treasury’s optics. After long negotiations, the bank stress tests were set to show most banks are close to have their Goldilocks level of capital (i.e., just right) Given that we generally agree (and the President has long stressed) this is the biggest financial crisis since the Great Depression, we seemed to be on the the verge of a capital adequacy miracle.

But instead of this being seen as some combination of good luck and smart policy, ”everyone is basically fine” would look like the banks are running the show. My Treasury friends swear up and down this is not true, but that is now beside the point. Whatever the reality, it looks increasingly to everyone like the banks really are in charge. It’s a nasty rule of politics that you are damaged by where perceived blame lands, rather than by what you actually do.

Perhaps the normal ebb and flow of the business cycle will mask over this continued giveaway to Wall Street interests. But Obama has long said that the financial industry must shrink in size and prestige relative to the economy. I see no way for that to happen in the current environment, which means we'll still be chasing bubbles well into the future, at the expense of ordinary Americans.

...Roubini and Richardson in the WSJ:

The hope was that the stress tests would be the start of a process that would lead to a cleansing of the financial system. But using a market-based scenario in the stress tests would have given worse results than the adverse scenario chosen by the regulators. For example, the first quarter's unemployment rate of 8.1% is higher than the regulators' "worst case" scenario of 7.9% for this same period. At the rate of job losses in the U.S. today, we will surpass a 10.3% unemployment rate this year -- the stress test's worst possible scenario for 2010 [...]

Stress tests aside, it is highly likely that some of these large banks will be insolvent, given the various estimates of aggregate losses. The government has got to come up with a plan to deal with these institutions that does not involve a bottomless pit of taxpayer money. This means it will have the unenviable tasks of managing the systemic risk resulting from the failure of these institutions and then managing it in receivership. But it will also mean transferring risk from taxpayers to creditors. This is fair: Metaphorically speaking, these are the guys who served alcohol to the banks just before they took off down the highway.

I just feel like there's no political will to do this, however necessary it may be.

Throwing More Money Down A Sewer

When the stress tests were first released late last week, the official line was that most banks remain well-capitalized, but should hold a reserve above the regulatory requirements just in case. Then we heard that at least one unidentified bank would need more capital, but everything else is OK. Today, we're getting some names:

Regulators have told Bank of America Corp. and Citigroup Inc. that the banks may need to raise more capital based on early results of the government's so-called stress tests of lenders, according to people familiar with the situation.

The capital shortfall amounts to billions of dollars at Bank of America, based in Charlotte, N.C., people familiar with the bank said.

Executives at both banks are objecting to the preliminary findings, which emerged from the government's scrutiny of 19 large financial institutions. The two banks are planning to respond with detailed rebuttals, these people said, with Bank of America's appeal expected by Tuesday.

The findings suggest that government officials are using the stress tests to send a tough message to struggling banks. Bank of America and Citigroup have been the highest-profile problem children in recent months, but it is unlikely that they are the only banks the Federal Reserve has determined might need more capital.

I don't think the rebuttals will exactly help. Of course BofA and Citi will insist that they're well-positioned. They've been saying that since well before receiving $45 billion dollars a piece in government money. Which helped mitigate the worst effects, but did not solve the problem, as we can plainly see.

And then there's that ominous last line, that it's "unlikely" that they're the only banks shown to be in trouble by the stress tests. Regions Financial Corp., Fifth Third Bancorp and Wells Fargo & Co. are mentioned as possibles. We've gone from zero banks in trouble to a healthy portion of the 19 studied in a matter of days. There's also a wonderful line in there where government officials say "banks directed to raise more capital shouldn't be viewed as insolvent." Um, isn't that the purpose of the stress test and the very definition of an insolvent firm? Apparently not, says Edward Harrison.

"Instead, the capital is intended to cushion the banks against potential future losses under dire economic conditions. Federal officials say they won't allow any of the top 19 banks to fail.

Still, it is unclear how flexible the government will be about adjusting the results, especially as banks plead their cases individually. Banks have until the middle of this week to lodge their formal responses to the tests. Bankers expect that will set the stage for several days of intense negotiations between the banks and their examiners."

Ah, I see, it is all a sham.

It sounds a lot like a test where the student banks who just failed go to the teacher regulator with mommy and daddy bank lobbyists in tow to see if they can get their grades changed higher. See, the stress are just a scheme to make us think the Federal government is actually doing something about the under-capitalized banking system in the U.S.. In reality, the Obama Administration is just buying more time in order to let us grow our way out of this problem.

While Larry Summers does appear to now believe that financial industry growth has been outsized, he adamantly asserts that the stress tests were designed to get the banks the capital they need, not to reveal their essential insolvency. No bank will be able to recapitalize entirely with private funds. This imagining of the stress tests is simply a recipe for more government largesse. While we may be on the right track to putting in the proper amount of sand in the gears to ensure this never happens again, I'm extremely troubled by the way out being seen as feeding the giant maw of the banks over and over and over again.

Re-Regulation Musings

Obviously, after we take our medicine and spend historic amounts of bailout money for the banks, we're going to need some serious re-regulation. This crisis was caused through a bipartisan failure to rein in runaway capitalism, and an unwillingness to set limits on the financial industry, until it grew too big to fail. The economy became unbalanced, driven by a sector that didn't produce goods but financial services, and when it made mistakes, we all paid the price.

There are some proposals already floating around. Some top Democrats want a new agency to regulate financial products.

On Tuesday, House and Senate Democrats, joined by Elizabeth Warren (who heads the commission overseeing the disbursement of bailout funds), announced a bill to create a Financial Product Safety Commission. The body would have oversight of mortgages and other financial instruments just as other commissions regulate the safety of toys, drugs or airplanes [...]

Warren, who has been singled out for seeing the roots of the economic collapse before it happened, highlighted how the commission would work and how it could have prevented the current crisis.

She offered the example of a loan with a low "teaser rate" and an obscured prepayment penalty. "Prepayment penalties are a way to try to fool [borrowers] into thinking the price is $1100 dollars a month -- that's the teaser rate -- when in fact the real price of this product is the equivalent of $1900 dollars a month. And if you try to refinance out of the product, you'll pay a prepayment penalty. That's how the company will make its money. You'll either pay higher interest later on, or you'll pay a prepayment penalty to get out of it."

When the price rises to $1900 a month or higher, the borrower can't refinance, can't make the payment, and goes into foreclosure.

"If there had been an agency, like the Financial Product Safety Commission, that had said, 'You just don't get to fool people on pricing,' then what would have happened is," she said, "there would have been millions of families who got tangled in predatory mortgages who never would have gotten them."

The idea of cooling down bubbles, which this would do because it would mean that not everyone with a pulse would qualify for a loan, strikes at the root of the crisis of the past 30 years with the US economy. It's also true that a new agency would have certain advantages, because it could be imbued with a certain stature and credibility (Obama could go far to help this along). But there are also steps that the current regulators could take, which could also get at this problem of discouraging bubbles and reckless activity from the banks. Simply put, the Fed could tie capital ratios to economic growth.

Capital ratios basically regulate the amount of leverage a bank is allowed to take on, and what Bernanke is suggesting here is that in good times, when animal spirits are high and anyone with a pulse is offered a no-down loan, capital ratios should be increased, thus reducing bank lending and keeping leverage within reasonable bounds. In bad times, when animal spirits are moribund and deleveraging shuts down the credit pipeline, capital ratios should be decreased, allowing banks to loan more money.

This has always struck me as a good idea. But Bernanke doesn't say how he thinks it should be done. Would a board of some kind make these decisions twice a quarter, the way the Fed does with interest rates? Or would there be some kind of automatic mechanism involved? If the former, what confidence do we have that they'd really be willing to take the punch bowl away during boom times? The Fed sure wasn't willing to do so during the 2002-07 expansion. Overall, this is a good suggestion, but it could bear some fleshing out.

There are lots of suggestions out there, like reinstituting Glass-Steagall, and killing the shadow banking system. Or setting a hard limit for leverage allowances. What would be unacceptable is just fixing the near-term crisis and going home. One of the reasons Tim Geithner does not reassure me is that he has such a close relationship to the banking industry and might be unwilling to place the necessary constraints on them.

...you actually know how important re-regulation is by seeing that Alan Greenspan doesn't think we need it.