Think Twice Finance

Fighting Our Way Out of the Banking Crisis: Paulson Takes the Ball.

The Credit Crisis seems to be approaching its nadir, although it is clear that we will lose several more banks, perhaps many of the smaller “me too” banks, before this experience is over. We seem to be moving into a phase that happens in every crisis from war to basketball. In this phase many of the participants in the crisis become strangely distant. Somebody (Gandi and Michael Jordan come to mind in politics and basketball) takes charge. When ventures go well, there are many leaders, but when trouble is in the air, there are precious few.

It appears in the case of the Credit Crisis that Henry Paulson is going to lead the way out, for better or worse. There was a photo of him explaining the administration crisis plan on the steps of the Treasury in the Sunday Times that spoke volumes. No assistant secretaries, Fed leaders, politicians high or low stood beside him. He stood alone on those steps.

The reason is simple. From here on out, there are going to be no heroes. In one form or another, the taxpayer is going to bear the burden of digging our way out of this mess, and although Paulson, among the leadership candidates, is by far the least culpable in creating our unfortunate circumstances, he’s going to lead the way out. He spent his career among the leaders of an investment bank that had unparalleled success at taking calculated managed risk, rather than the government subsidized scams called banking that brought us to this sorry state.

He seems to be a person to be taken seriously. There is no preening, nor is there any shrinking away. If so, we’re lucky because there is much to be done and all of it will be criticized by the more simian of our legislative representatives.

Yet the Wall Street Journal Editorial today (July 15, 2008) raises the question whether Paulson became Secretary of the Treasury to “pad his obituary” or contribute to his country. In my mind, that question has already been answered.

Posted in leadership, Markets and Regulation, Federal Housing Agencies, When Regulation Goes Wrong | No Comments »

Fannie Mae and Freddie Mac: Nowhere to Run, Nowhere to Hide, Baaybee!!

I’ve been waiting for thirty years. That’s when I first heard Milton Friedman predict that the real United States Deficit problem was not the one we all talk about. It is the one that will hit the fan when the Treasury assumes the Obligations of Freddie Mac and Fanny Mae, the major quasi-private lending institutions.

Thirty years ago, that debt was a whopping amount of money. But it is dwarfed by the mortgage protection provided by these Agencies today. They protect or own over  half the US  mortgages outstanding. The amount of their exposure is in the neighborhood of $5 trillion, enough to double the existing public debt of the United States if the Treasury took the obligation onto its books. The crisis has deepened under Democratic and Republican administrations alike, and under any number of Federal Reserve Chairmen, so the politics and finger-pointing with which we will be bombarded is just so much talk.

As Paul Voelker, former Chairman of the Federal Reserve, therefore no longer prevented from telling the truth, points out that the new debt is enough added risk to threaten the country’s AAA credit rating, and that means an increase in the tax bill that I don’t even want to contemplate.

The banking system and the bank regulators, congressmen and senators alike, have been quietly letting this problem grow throughout the thirty years since Friedman made his prediction. One regulation has been piled on top of another. Loophole has followed loophole.

However, it appears that we have reached the endgame. The Crisis within a Crisis seems to have erupted when Lehman indelicately pointed out that Freddie’s assets were not of sufficient value to pay off its debt. Ordinary companies become insolvent under these circumstances of course. But investors from Joe Public to Central Banks of other countries have been treating this debt like the Rock of Gibraltar since these agencies were created and nobody seems interested in finding out what would happen if they were to become insolvent.

So what’s a regulator to do? Well, give a lot of congressional testimony for starters. And then it seems, look for a way to convince the world that the Treasury promises to see that the debt is paid without a doubt, yet without actually promising to be the one to pay it. The second part is the tricky one when the amount is $4 trillion.

The plan at the moment seems to be to put the companies into conservatorship. This is an accounting “method” (notice I didn’t use the word “gimmick.” I would never accuse our government of using accounting gimmics. No sir.) This “method” means the government doesn’t actually assume the debt of the agencies. The agencies still owe the money. But if the agencies should be unable to pay what they owe, the government would. You can see that’s not a gimmick, of course. That’s very straightforward. So different from the government accepting responsibility for paying the debt. Thank God for plain speaking bureaucrats. I bet Henry Paulson and Ben Bernancke wish they were somewhere else. Say, interred in Guantanamo Bay.

Posted in Rating Agencies, Creative Accounting, When Regulation Goes Wrong | No Comments »

The Coming Regulations For Financial Institutions: Don’t Worry. Be Happy.

It has been clear since the outset of the Credit Crisis (see “Mortgage Debt Crisis,” September 10, 2007 post, this blog.) that the investment banks were going to be regulated by the Federal Reserve. Secretary of the Treasury Paulson set a four year deadline to implement his then unspecified “update” of bank  regulation. He has obviously accelerated his plans. It has been clear since the bail-out of Long Term Capital that the Fed’s defacto regulatory umbrella covered far more than deposit-taking institutions.

While I oppose defacto regulation of investment banks by the Federal Reserve, given the moral hazard created by defacto Fed bail-outs, I want dejure Fed regulation. Dejure regulation, it is my hope, will eventually force the public to come to terms with the implications of cosseting the banks. To wit: Banks cease being creative and become unprofitable, requiring hidden government subsidies to survive. These subsidies are among the two or three important causes of The Credit Crisis.

In my opinion the deal to give the Fed the go-ahead to regulate the investment banks was sealed, interestingly enough, in far-off Australia. There, we find the two most profitable financial institutions on the globe (if I may be permitted not to count Moodys) Macquarie and Babcock & Brown. B&B, known down under as “Lil’ Mack,” has been the more profitable of the two since it went public in 2002. Its operations remind one very much of those of Macquarie, with one exception. It was never a commercial bank. Macquarie, on the other hand, was a bank.

Early in the crisis, Macquarie lost its patience with bank regulators. It simply turned in its banking license, taking the name Macquarie Group. Its motives were crystal clear. Macquarie stated that bank regulation reduced its profitability.  Macquarie also announced that it planned no operational or personnel changes. Interestingly, investors provided an additional $8 billion in financing to the new non-bank. More interestingly, most of the investors were large regulated banks.

Had that decision become a trend, it would certainly have left the Fed naked on the beach. So have no doubt. Investment banking, as a category of American financial institution, is dead.

Why, then, do I say, “Don’t worry. Be happy?” The reason is that I saw this coming long ago, and I adjusted. That means that any banker with half a brain saw this coming long ago and has also planned to adjust. “How?” you may ask. Ah… but that I cannot say. In the business of banking, one must stay one step ahead of the posse. The analogy between posses and bank regulators may not be apt. A posse is a blood-thirsty mob. Bank regulators are…, well….

So good bankers will not die. They will find someplace more opaque to do what they do. Maybe hedge funds. Maybe private equity. Maybe Australia.

Posted in Australia, Games Bankers Play, The Banking Crisis, Polticial Decisions Affecting Banking | No Comments »

The Future Structure of Financial Institutions: Will the Fed Swallow the Investment Banks?

In the June 24^th WSJ (“Maybe It’s Time to Put the Banks and the Investment Banks Back Together.”) Dennis Berman forecasts the demise of investment banks. I could not disagree more with his thesis, that transaction-based institutions have become obsolete, since their ratios of risk to anticipated return have become excessively large. But I do suspect that if he waits a few years (perhaps less) it will appear that he’s right.

But that is because appearances deceive. What happened in the wake of the banking crisis was a naked power grab by global bank regulators, who have rewritten history in real time as this financial crisis has unfolded. They have created a convenient fiction - “The Shadow Banking System,” – an imaginary entity including some financial instruments and markets and some institutions, notably the investment banks, that regulators contend are “outside their purview.”

Nonsense. As I and several others have pointed out, the legislation that followed the Enron fiasco gave the accountants authority to eliminate the “variable interest entities” that gave the large banks the ability to take near-infinite leverage against mortgage vehicles. The accountants passed rules eliminating this practice, only to be thwarted by Federal Reserve lobbying to protect the banks’ ability to take what turned out to be unconscionable risks.

The investment banks had this power as well, but it is quite clear that the leveraged vehicles that precipitated the crisis were to be found primarily at the former “money center” banks that have been flopping around on the shores of finance for decades being kept alive by dubious regulatory decisions of this sort. Imagine the regulators’ glee when they discovered that a couple investment banks, whose philosophy more generally has always been anti-inventory, were so poorly managed that they held large inventories of these securities. Indeed in the case of Bear Stearns, management near-indifference to their problems, along with direct pressure from the Treasury, resulted in Federal Reserve assisted closure of the firm, sold to JP Morgan for a token amount.

This little slight-of-hand provided the opportunity to assign blame for excessive leverage to the investment banks, not the banks, and to give the whole idea of an unregulated shadow banking system some credibility. All you have to do is imagine that the regulated banks were not riskier than the unregulated investment banks, forget that the large banks have been unprofitable for a decade, and ignore the exodus of the quality banking talent from investment banks to the hedge funds and private equity firms, where bankers can still make money by being creative rather than by taking new government-subsidized risks.

So I think the days of a separate business called investment banking are indeed numbered, a belief that predated Bear Stearns, based on comments of bank regulators. But the investment bankers themselves will find a way to do their thing.

Posted in Creative Accounting, Bank Management, When Regulation Goes Wrong | No Comments »