September 23, 2008

New York Times Editorial

Trust Me

The nation’s financial mess was caused to a great degree by a culture of lax regulation and even less oversight, in which ordinary Americans were told to trust the government and Wall Street to do the right thing.

President Bush’s proposed solution, which he wants Congress to authorize immediately, tells taxpayers to write a check for $700 billion and trust the government and Wall Street to do the right thing — with inadequate regulation and virtually no oversight.

We agree with Senator Barack Obama that the administration’s plan lacks regulatory muscle, and we agree with Senator John McCain when he said: “When we’re talking about a trillion dollars of taxpayer money, ‘trust me’ just isn’t good enough.”

Nearly everyone agrees that the there will have to be another very big bailout. The financial system, gorged on its own excesses, cannot stabilize without intervention. The $700 billion would be used to buy up the bad assets that are presumably clogging the system.

To protect the American taxpayer, Congress must ensure that the bailout comes with clear ground rules and vigilant oversight. In an appalling, though familiar fashion, the ground rules proposed by the Bush administration are wholly unacceptable — as are its tactics.

At 1 o’clock in the morning on Saturday, the Treasury Department released its “Legislative Proposal for Treasury Authority to Purchase Mortgage-Related Assets.” The witching hour timing seemed designed to underscore the urgency of the effort.

The proposal, which is now being negotiated with Congressional leaders, would give the Treasury secretary the authority to buy any assets from any financial institution at any price that he deemed necessary to provide stability to the financial markets. And it asserts that neither the courts nor any administrative agency would be allowed to question or review those decisions.

We’ve seen this kind of over-reaching from the Bush administration before. It has usurped far too many powers under a banner of urgency — think wiretapping — and abused those powers. Now, Congress and the American people are being told that unless they quickly approve sweeping executive powers for the bailout, capitalism may collapse. Even if this administration weren’t so untrustworthy, rushing ahead would be a bad idea.

No one is saying the financial crisis is not serious and urgent. We know that it will be hard for lawmakers to resist White House pressure — especially if the Dow continues to drop. But it is essential that Congress takes the time to get the bailout right, even if it cuts into lawmakers’ campaigning.

Treasury Secretary Henry Paulson must craft and execute the bailout in a way that persuades Wall Street and the global financial system that they will be saved while protecting the American taxpayers’ $700 billion investment. Balancing those complex mandates is made more difficult by the fact that Mr. Paulson hails from Wall Street and could, if he wanted to, return to Wall Street.

The only way to avoid the appearance of a conflict of interest is for Mr. Paulson to welcome full and transparent legislative and judicial review.

A counterproposal now being developed by the Democrats would require firms that sell their troubled assets to the Treasury to give the government stock — an idea that has populist appeal but also needs to be vetted carefully. It also would try to help homeowners, who are left out of the administration’s plan entirely, allowing them to have their mortgages modified under bankruptcy court protection. That step that should have been taken long ago to avert the foreclosures and house price declines that are at the root of the crisis.

Senator Christopher Dodd, chairman of the Senate Banking Committee, is also calling for an oversight board of federal officials and other experts. We believe that is still not enough. But all of the competing proposals provide interesting starts for a serious debate.

There is time to have it.

September 22, 2008

New York Times Op-Ed Columnist

Cash for Trash

By PAUL KRUGMAN

Some skeptics are calling Henry Paulson’s $700 billion rescue plan for the U.S. financial system “cash for trash.” Others are calling the proposed legislation the Authorization for Use of Financial Force, after the Authorization for Use of Military Force, the infamous bill that gave the Bush administration the green light to invade Iraq.

There’s justice in the gibes. Everyone agrees that something major must be done. But Mr. Paulson is demanding extraordinary power for himself — and for his successor — to deploy taxpayers’ money on behalf of a plan that, as far as I can see, doesn’t make sense.

Some are saying that we should simply trust Mr. Paulson, because he’s a smart guy who knows what he’s doing. But that’s only half true: he is a smart guy, but what, exactly, in the experience of the past year and a half — a period during which Mr. Paulson repeatedly declared the financial crisis “contained,” and then offered a series of unsuccessful fixes — justifies the belief that he knows what he’s doing? He’s making it up as he goes along, just like the rest of us.

So let’s try to think this through for ourselves. I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”

The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis?

Well, it might — might — break the vicious circle of deleveraging, step 4 in my capsule description. Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.

Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I’m not happy with this plan?

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

That’s what happened in the savings and loan crisis: the feds took over ownership of the bad banks, not just their bad assets. It’s also what happened with Fannie and Freddie. (And by the way, that rescue has done what it was supposed to. Mortgage interest rates have come down sharply since the federal takeover.)

But Mr. Paulson insists that he wants a “clean” plan. “Clean,” in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out. Why is that a good thing? Add to this the fact that Mr. Paulson is also demanding dictatorial authority, plus immunity from review “by any court of law or any administrative agency,” and this adds up to an unacceptable proposal.

I’m aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications that make it slightly less bad. Basically, after having spent a year and a half telling everyone that things were under control, the Bush administration says that the sky is falling, and that to save the world we have to do exactly what it says now now now.

But I’d urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don’t let yourself be railroaded — if this plan goes through in anything like its current form, we’ll all be very sorry in the not-too-distant future.

Get Angry

Excerpt from

Aaron Sorkin Conjures a Meeting of Obama and Bartlet

By MAUREEN DOWD

Published: September 20, 2008 (The New York Times)

...

OBAMA The problem is we can’t appear angry. Bush called us the angry left. Did you see anyone in Denver who was angry?

BARTLET Well ... let me think. ...We went to war against the wrong country, Osama bin Laden just celebrated his seventh anniversary of not being caught either dead or alive, my family’s less safe than it was eight years ago, we’ve lost trillions of dollars, millions of jobs, thousands of lives and we lost an entire city due to bad weather. So, you know ... I’m a little angry.

OBAMA What would you do?

BARTLET GET ANGRIER! Call them liars, because that’s what they are. Sarah Palin didn’t say “thanks but no thanks” to the Bridge to Nowhere. She just said “Thanks.” You were raised by a single mother on food stamps — where does a guy with eight houses who was legacied into Annapolis get off calling you an elitist? And by the way, if you do nothing else, take that word back. Elite is a good word, it means well above average. I’d ask them what their problem is with excellence. While you’re at it, I want the word “patriot” back. McCain can say that the transcendent issue of our time is the spread of Islamic fanaticism or he can choose a running mate who doesn’t know the Bush doctrine from the Monroe Doctrine, but he can’t do both at the same time and call it patriotic. They have to lie — the truth isn’t their friend right now. Get angry. Mock them mercilessly; they’ve earned it. McCain decried agents of intolerance, then chose a running mate who had to ask if she was allowed to ban books from a public library. It’s not bad enough she thinks the planet Earth was created in six days 6,000 years ago complete with a man, a woman and a talking snake, she wants schools to teach the rest of our kids to deny geology, anthropology, archaeology and common sense too? It’s not bad enough she’s forcing her own daughter into a loveless marriage to a teenage hood, she wants the rest of us to guide our daughters in that direction too? It’s not enough that a woman shouldn’t have the right to choose, it should be the law of the land that she has to carry and deliver her rapist’s baby too? I don’t know whether or not Governor Palin has the tenacity of a pit bull, but I know for sure she’s got the qualifications of one. And you’re worried about seeming angry? You could eat their lunch, make them cry and tell their mamas about it and God himself would call it restrained. There are times when you are simply required to be impolite. There are times when condescension is called for!

Bailout Blues

September 21, 2008

Fair Game
The New York Times

Your Money at Work, Fixing Others’ Mistakes

By GRETCHEN MORGENSON

IT looks as if we may get through this weekend without another scramble to save a troubled financial firm with a trillion-dollar balance sheet.

But that doesn’t mean taxpayers are out of danger. No, sir. No, ma’am. Because lawmakers are at work on a bailout fund that would buy the kind of distressed assets (defaulted mortgages, for example) that have ignited this firestorm.

Treasury Secretary Henry M. Paulson Jr. has called the fund the “troubled asset relief program.” I’ll just call it TARP for short (you know, the kind of thing they spread over muddy fields so you don’t soil your Guccis).

And depending on how TARP is operated, and how the assets are valued before taxpayers are forced to buy them, it could bloat our final bill for this mess while benefiting the very institutions that got us into it.

Yes, we need a smart plan and a concerted effort to get the frozen credit markets up and running. But we also have to be certain that the types of conflicts of interest that riddle Wall Street aren’t visited upon TARP.

Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky mortgage securities that it currently values at 60 cents on the dollar. Let’s assume that the most recent actual trade between market participants for similar assets was struck at 30 cents on the dollar.

So what’s a fair price that we TARPistas should pay for the assets?

If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face a loss. The bank, however, would be much better off than if it had to dump at 30 cents.

Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the purchase if the assets performed better than expected over time. But the bank would have to write down the value of the assets as a result of the sale, possibly threatening its financial standing yet again.

Do you think, perchance, that financial services lobbyists might be working their Hill contacts right this very minute to ensure that the TARP valuations are rigged in their favor?

You know the answer to that.

And you also know that we should steel ourselves for heavy losses as the TARP gets pulled over our eyes. Never mind that it was the banks, with their reckless lending and monumental leverage, that drove us into this ditch.

Such is our lot today: They break it. We own it.

Taxpayers deserve better than this, of course. But we have no lobbyists, so we get skinned.

IF federal regulators and political leaders want to earn back some trust, they could do two things. First, they could provide us with some transparency about whom precisely we are backing in the recent bailouts.

Take, for example, the rescue on Tuesday of the American International Group, once the world’s largest insurance company. It was pretty breathtaking. Since when do insurance companies, whose business models seem to consist of taking in premiums and stonewalling claims, deserve rescues from beleaguered taxpayers?

Answer: Ever since the world became so intertwined that the failure of one company can topple a host of others. And ever since credit default swaps, those unregulated derivative contracts that allow investors to bet on a debt issuer’s financial prospects, loomed so big on balance sheets that they now drive every bailout decision.

The deal to save A.I.G. involves a two-year, $85 billion loan from taxpayers. In exchange, the new owners — us — get 80 percent of the company. If enough of A.I.G.’s assets are sold for good prices, we may get our money back.

Credit default swaps, which operate like insurance policies against the possibility that an issuer of debt will not pay on its obligations, were the single biggest motivator behind the A.I.G. deal.

A.I.G. had written $441 billion in credit insurance on mortgage-related securities whose values have declined; if A.I.G. were to fail, all the institutions that bought the insurance would have been subject to enormous losses. The ripple effect could have turned into a tsunami.

So, the $85 billion loan to A.I.G. was really a bailout of the company’s counterparties or trading partners.

Now, inquiring minds want to know, whom did we rescue? Which large, wealthy financial institutions — counterparties to A.I.G.’s derivatives contracts — benefited from the taxpayers’ $85 billion loan? Were their representatives involved in the talks that resulted in the last-minute loan?

And did Lehman Brothers not get bailed out because those favored institutions were not on the hook if it failed?

We’ll probably never know the answers to these troubling questions. But by keeping taxpayers in the dark, regulators continue to earn our mistrust. As long as we are not told whom we have bailed out, we will be justified in suspecting that a favored few are making gains on our dimes.

A.I.G.’s financial statements provided a clue to the identities of some of its credit default swap counterparties. The company said that almost three-quarters of the $441 billion it had written on soured mortgage securities was bought by European banks. The banks bought the insurance to reduce the amounts of capital they were required by regulators to set aside to cover future losses.

Enjoy the absurdity: Billions in unregulated derivatives that were about to take down the insurance company that sold them were bought by banks to get around their regulatory capital requirements intended to rein in risk.

Got that?

Which brings us to Item 2 for policy makers. Stop pretending that the $62 trillion market for credit default swaps does not need regulatory oversight. Warren E. Buffett was not engaging in hyperbole when he called these things financial weapons of mass destruction.

“The last eight years have been about permitting derivatives to explode, knowing they were unregulated,” said Eric R. Dinallo, New York’s superintendent of insurance. “It’s about what the government chose not to regulate, measured in dollars. And that is what shook the world.”

And it will continue.

The Bailout

September 20, 2008

New York Times Editorial

Hard Truths About the Bailout

The fifth major federal bailout this year — after Bear Stearns, Fannie Mae, Freddie Mac and the American International Group — is now in the works. Taxpayers have every right to be alarmed and angry. The latest plan is not necessarily a bad one, and officials had to move quickly to prevent credit markets from seizing up.

But make no mistake, this crisis could have been avoided if regulators had enforced rules and officials had dared to question risky lending and other dubious practices.

If done right, this bailout could succeed where the others have failed and remove the threat of a systemwide financial collapse. But the upfront cost will be enormous. So will the risk of losses in the long run — on top of the risks already incurred.

The new plan would commit taxpayer money to buy hundreds of billions of dollars of troubled loans and other mortgage-related securities from banks and Wall Street firms. It is based on the reasonable premise that as long as institutions are stuck with those assets, the flow of credit, the economy’s lifeblood, will be constrained, or as in the past week, all but frozen.

Congress, with one eye on this week’s volatile Dow and the other on November’s election, could authorize the plan as early as next week.

It is painfully clear that the financial system will not rebound on its own from the excessive lending and borrowing of the Bush years and the credit collapse in their wake. The one-bailout-at-a-time approach hasn’t worked. And modest steps are no longer an option.

Lawmakers and administration officials must be prepared to tell Americans the full, hard truths about this plan:

¶ What is this going to cost the taxpayers and who decides? It’s generally believed that many of the troubled assets that the government would buy will, in time, be worth more than they can fetch in today’s chaotic markets. That’s far from a sure thing. The assets are tied to housing, so their value will depend on how far prices fall, how many people end up defaulting and how long it takes before housing rebounds — all big unknowns.

For those reasons, it’s important for Americans to know who is going to decide what is the right purchase price for these assets. Wall Street will have a role, of course, but outside experts should be allowed to analyze the results. Americans also need to know how the process will be monitored to ensure that taxpayers’ interests are protected. If the government gets the price right, the upfront outlay could be recouped when it later sells. If it overpays, the taxpayer is stuck with the loss.

¶ How will Congress balance the bailout of Wall Street and the needs on Main Street? If financial markets stabilize, all Americans will benefit. But Congress must do more to provide direct help to struggling American families. Lawmakers should use the bailout legislation to also extend unemployment benefits, bolster food stamps and provide aid to state and local governments to provide health care and other services that are especially important during tough times.

¶ The administration and lawmakers also need to tell Americans that the era of cheap and easy money is over and that there are more tough times to come. Whose taxes will have to go up? How will the government help to create the jobs of the future? How will the most vulnerable Americans be protected? And they need to explain that the cost of the bailouts will compete with other spending.

¶ Finally, Americans need to be told a more fundamental truth: This crisis is the result of a willful and systematic failure by the government to regulate and monitor the activities of bankers, lenders, hedge funds, insurers and other market players. All were playing high-stakes poker with the financial system, but without adequate transparency, oversight or supervision.

The regulatory failure, in turn, was grounded in the Bush administration’s magical belief that the market, with its invisible hand, works best when it is left alone to self regulate and self correct. The country is now paying the price for that delusion.

If lawmakers and administration officials really want to restore confidence, the bailout must be only a first step. The hard work of establishing and enforcing the regulations that are needed for a truly trustworthy financial system, still lies ahead.

Investing in Stocks

September 18, 2008

New York Times Op-Ed Contributor

For Wall Street, Greed Wasn’t Good Enough

By PAUL WILMOTT

London

I’M fairly risk-averse by nature and so have always ignored the offers from my bank to help me “manage my money more successfully.” Put the money in a savings account, earn a bit of interest, but mainly work hard, that’s been my philosophy. Like everyone else, though, I’ve been looking into the small print lately to see just how safe my safe-as-houses account really is.

In Britain, the government will guarantee roughly the first $62,000 in a bank account. If you have more than this saved up then an obvious solution is to spread the money around several accounts. Fine in theory, but this rapidly becomes tedious if you want to protect the savings of a lifetime. So finally I succumbed to the calls from my bank manager. As of the middle of last week I have a man who will give me advice day or night, and crucially can help someone as conservative as me to not suffer while all hell breaks loose.

At our first meeting, one of the questions I raised was how to deal with the money I owe the tax man. Could he recommend a safe yet interest-bearing haven where I could keep the money until Her Majesty’s Government asks for it? He proposed an insurance bond that will mature on the date I have to pay my taxes. Insurance bonds have the nice feature that 90 percent of your money is insured, with no cap, and so even in a disaster I would lose “only” 10 percent. This is how my first venture outside my comfort zone ended with me being invested in American International Group.

When I hear about the potential collapse of A.I.G. shortly thereafter, I contacted my manager. “We are in talks with A.I.G.,” he tells me.

“I want out!” I tell him.

Luckily for me, I’m within a cooling-off period in which I can get my money back, losing none of the principal. At least I think I am. I hope. I’ll know more in the next couple of days. Even though A.I.G. has now apparently been rescued by the Federal Reserve and downgraded relatively little — and even though I can theoretically lose only 10 percent, with the rest being insured — I want to play it safe.

That last sentence contains quite a few important concepts that are all worth thinking about. First of all, “the rest being insured ...” Insured by whom, exactly? The main problem with the current crisis is not just that all financial institutions are now intertwined, but rather the new manner of this interlacing through their complex derivatives transactions. In the Long-Term Capital Management hedge fund mess of 1998, the transactions were fairly transparent and with obvious counterparties. The cancer, if I may use that dramatic word, was contained and operable. (The long-term impact for me, as someone who researches and lectures on finance, is that I can tell some great tales about the fall to earth of Nobel laureates who tried to put their theories to work in the real world.)

The current crisis, however, is nowhere near as simple. The cancer has metastasized — it has spread through all the organs of the financial markets and a straightforward excision is probably not possible. That’s what makes the question of whether to rescue each institution such a difficult one. Sure, people have to learn a lesson. But, and this is my final surgical analogy, would that be cutting off one’s nose to spite one’s face?

Back to my money with A.I.G., I ask myself, “Who insures the insurers?” I want out.

I mentioned “downgrading.” Institutions and products are graded by various credit-rating firms so as to supposedly give an objective view of the risks and of the possibilities of default. Can anyone say, while keeping a straight face, that the current system of having the institutions themselves pay for this service is a good idea? The moral hazard is so obvious you can almost taste it.

I spend a great deal of time speaking to people in banks about their mathematical models. I know which are using good models (a very few banks) and which are using bad models (most banks). I know of the dangers present, from a quantitative-finance and risk-management perspective. And for many years I have explained these dangers to anyone who would listen, and I will continue to do so. So it is incredible to think that ratings agencies, which must also have detailed knowledge of the nature and, more important, size of the toxic transactions, will happily give out their multiple A grades without any feeling of shame.

And then the word “theoretically” becomes very important. I have attended many conferences on quantitative finance, at which professors and practitioners describe their latest models for derivative instruments and the like. All the time I’m sitting in the audience thinking that these models are far too simplistic and based on countless unrealistic assumptions. I tell people that these instruments are dangerous, that no one understands the risks. But no one cares.

As long as people are compensated hugely for taking risks with other people’s money, and do not suffer equally on the downside, then those risks will inevitably become outrageous. Whether markets are efficient or not I don’t know for sure, but I do know that if there’s a way for someone to make money at another’s expense, he will. In spades. I want out.

So where next? And, most important, what should be done?

I’ve taken to comparing the current situation to “Hamlet.” We’ve had the deaths of Polonius, Claudius and Laertes — that is, the falling house prices, the rising commodity prices and the collapse of banks. As of now there is no sign of Hamlet himself, a catastrophic fall in the markets. Yet it’s difficult to believe that markets are not going to undergo a climactic implosion some time soon. If the current situation doesn’t fill investors with fear, then what are they smoking?

I believe that to get to the root of the matter, we have to address the bad side of greed. We know from Ivan Boesky and Gordon Gecko that greed can be good. Greed makes the world go around; it makes people take risks that ultimately lead to economic or scientific advances. But the greedy must also face the consequences of taking those risks.

Thus the current system of compensation at financial companies does not lead to anything good at all. If you give $10 million to random people on the street and tell them that they’ll get 20 percent of any profit they make, without any consequences if they lose it, then many of them will go into the nearest casino and bet it all on red. (The really clever ones will find a way to leverage it up first — after all, a $2 million bonus is nothing; you can’t seriously expect people to live in New York or London on less than eight figures, can you?)

Many Lehman Brothers employees received some of their compensation in Lehman shares. They aren’t feeling too happy right now. But a system run on that principle could achieve exactly what is needed: a closer link between a person’s paycheck and the longer-term success of his trading. At the moment, a trader can sell a 10-year toxic contract, pocket a nice bonus after a few months based on some theoretical valuation, and then disappear to another bank or off into the sunset, leaving nine years in which that contract could blow up.

These companies need to tie compensation to long- rather than short-term performance. This won’t be popular on Wall Street, but if we want to turn investment banking back to performing something useful and positive rather than some sort of riverboat-gambling scheme on which we are all unwitting participants, then there’s not much choice.

Meanwhile, I will be in contact with my new best friend, the bank manager, day and night. I will be closely monitoring every twitch of A.I.G.’s share price, balance sheet and credit rating. And I’ll just hope that if all does not end well, Her Majesty’s Government is understanding of this loyal, faithful and increasingly risk-averse subject.

Paul Wilmott is the founder of Wilmott, a journal of quantitative finance.