Author: Daniel Indiviglio

So just how badly did the financial crisis screw up growth prospects for the United States? Moodys chief economist Mark Zandi has an answer. And it’s disturbing. His testimony (.pdf) before the Financial Crisis Inquiry Commission addresses precisely this topic. I found the most alarming section of his testimony Moodys’ projection of would happen to GDP in the long run, due to the crisis. The associated chart provides a frightening picture of the depth of its effects.

Here’s the full section about GDP in the Long Run, which includes the chart:

Fallout from the financial crisis will continue well beyond the current recovery. Most critically, it will likely lower GDP for an extended period. That is, GDP will not return to the level that would have prevailed if the financial crisis had never occurred, at least not for the next five to 10 years. This is similar to the experiences of other economies that have suffered similar financial crises. Real U.S. GDP is expected to be some 4% lower 10 years from now than it would have been if the financial crisis had been avoided (see Chart 10).

The lower GDP stems from a smaller labor force–some unemployed workers never find a job and eventually give up looking–a lower capital stock due to less investment, and reduced total factor productivity. There is strong evidence that the labor force will be smaller. Labor force participation has fallen to 64.6% from 65.8% a year ago and above 67% at its peak a decade ago. Workers in their 50s and 60s with less education and skill face dim job prospects and are more likely to be forced into retirement. Many held manufacturing and construction jobs that are gone forever, and live in parts of the country where it will be difficult to sell a home and move.

Business investment spending has also been severely depressed by the financial crisis, causing the nation’s manufacturing capital stock to decline. During the 12 months ending last November, capital stock fell almost 1%. The only other such decline came in the technology bust a decade ago, which followed a lengthy boom in the late 1990s. In the expansion leading up to the current period, the fastest the capital stock grew was closer to 2%.

If Zandi’s right, then this is really bad. That graph shows the effect of the financial crisis on real GDP all the way through 2020 — more than a decade after it took place. It shows that if the U.S. economy would have had, say, 6% real GDP growth between 2015 and 2020 — which is pretty healthy, by the way, then that real GDP will now be a meager 2% instead, courtesy of the financial crisis.*

*Correction: As a few commenters have pointed out, this chart is actually talking about simple % decrease of future GDP — not GDP growth — in the years shown. Probably 99 times out of 100 when you see a graph dealing with GDP that has % on the vertical axis and years on the horizontal axis, it’s talking about growth, which is why I interpreted it in this way. Zandi’s office confirmed that this is that other rare case.

So the graph isn’t nearly as dramatic. It says that, after 2010, growth will no longer be affected, which is actually surprisingly optimistic in my opinion. But even then, it still shows that the U.S. will have taken a permanent hit in GDP. In other words, we’ll never get back some of the economic value lost during the financial crisis. So I think the graph is still scary, but not as scary as originally thought.

During the Financial Crisis Inquiry Commission’s second panel of the day, I got a real treat: an introduction to Kyle Bass. He’s a managing partner at Hayman Advisors. He’s also, by far, the smartest person I’ve heard testify all day. And that includes the CEOs of four of the most major banks. His testimony is worth noting.

I also managed to catch Mr. Bass on an interview with CNBC this morning. That video is included at the end of this post. His written testimony before the commission can be found here (.pdf).

I just wanted to excerpt a few parts, however, because it’s so valuable. He’s highly concerned about leverage, as am I. I’ve said before that leverage was the reason why we had a crisis. Bass explains:

A fundamental tenet of the US banking system is leverage. Using current regulatory guidelines, banks are deemed “well capitalized” with 6% Tier 1 capital and “adequately capitalized” with 4% Tier 1 capital based upon risk weighted assets (as an aside, the concept of risk weighted assets should also be reviewed). This in turn means a well capitalized bank is levered 16X to its Tier 1 capital (much more to its tangible common equity) and an adequately capitalized bank is 25X levered to its Tier 1 capital. How many prudent individuals or institutions can possibly manage a portfolio of assets that is 25X levered? Again, unfortunately, the answer has turned out to be not many. Of the 170 banks that have failed during this crisis, the average loss to the FDIC is well over 25% of assets, or more importantly 6 times their minimum levels of regulatory equity. Depository institutions like Citibank were able to parlay their deposits into large levered bets in the derivatives marketplace. In fact, at fiscal year‐end 2007, Citigroup was 68.4X levered to its tangible common equity, including off‐balance sheet exposures. According to the following table, real leverage at the institutions in question got completely out of hand:

(click on chart for a legible version)

I couldn’t agree more with Bass on this one. Even if you ignore the final row above and just look at “Gross Leverage to Tangible Common Equity,” those are clearly dangerous levels. Look at Citi. It was leveraged 68.4%. That means for every $68.4 dollars it had at risk, it had $1 of cushion. Put another way, if its assets incurred just 3% losses, it will have eaten through its capital, twice.

Realize: this guy is a private sector financial advisor who managed to make these calculations based on public filings. If he could do it, what was preventing the regulators like the Federal Reserve from doing so? And if regulators knew leverage was at such ludicrous levels, why were they so comfortable? Was there no conceivable scenario where Citi could suffer, say, 2% losses and blow through all of its capital?

In fact, in responding to questions today before the commission, Bass explains that he also calculated that, even if the housing prices just remained flat — not declining — for several years, the loses to some mortgage securities created by Wall Street would be catastrophic. He brought these concerns to Bear Sterns prior to its failure. Its bankers were unimpressed. Then he talked to a Federal Reserve official — one of the guys who want more regulatory power to oversee systemic risk. He also dismissed it. The Fed explained its economists believed that home prices would continue to rise, because economic indicators were good. Sure, Bass was only one data point, but his argument was compelling.

Here’s another amazing excerpt about Fannie and Freddie, which he spends a few pages of his testimony on:

Fannie and Freddie used the most leverage of any institution that issued mortgages or held mortgage backed bonds. At one point in 2007, Fannie was over 95X levered to its statutory minimum capital with just 18 basis points set aside for losses. That’s right, 18 one hundredths of one percent set aside for potential losses. They must not be able to put humpty dumpty back together again.

If you have the time and interest, I’d strongly suggest you look at all of Bass’ testimony. It’s enlightening stuff. He also addresses derivatives reform and several other topics. I’m more impressed by his understanding of finance, economics and global markets than pretty much anyone I’ve ever heard on CNBC. Here’s that video:

There’s been much talk this week about the Obama administration’s desire to obtain $120 billion from the banks with a new tax, especially for them. The President is expected to explain that tax tomorrow, but the Wall Street Journal managed to get a leak ahead of time. From what it’s learned, the tax appears to be on big banks’ net liabilities. In other words, the more a bank’s liabilities outweigh its assets, the more it will owe. Put one more way, the more highly leveraged a bank, the more it will have to pay. It’s effectively an excise tax on leverage.

Here’s the WSJ’s description of the calculation:

The government would likely calculate liabilities by subtracting the total of a bank’s equity and insured deposits from its assets

So, in a sense, the less capital that a bank has to back up its bets, the more it will owe Uncle Sam. It taxes unprotected risk. From a historical perspective, a tax like this isn’t shocking. Taxing behaviors that the government deems unsavory is one of its favorite pastimes. Just ask smokers how much they pay for their cigarettes.

If the administration wishes to create this tax as a sort of regulatory check on risk, then that would sort of makes sense (see the next paragraph). But that doesn’t appear to be what it’s doing here. According to what I’ve read, the tax would only exist for a few years, until the $120 billion mark has been reached. Then it will disappear. Maybe I’m missing something, but I’m not sure how a temporary tax on big banks’ risks to pay for costs resulting from mortgage modifications and the bailouts to the auto companies and AIG makes sense on really any level.

But what about as a permanent regulatory measure? There’s certainly an argument for a framework like this. The tax revenues could sit in a sort of “just in case” fund, to be used in times of financial emergencies. Then, if another financial crisis hits, any costs borne by the government in cleaning up the mess could be covered by the fund.

I still think it’s a silly idea, however. If you’re want banks to have less leverage, then just create leverage limits. Isn’t that a simpler, cleaner approach than trying to determine a tax rate to pay for the cost of impending doom if highly leveraged banks fail? Why should we want a financial system where banks can take unlimited risks, as long as they’re okay with paying the associated tax for doing so? I’d prefer stability, and a more direct approach.

As Day 1 of the Financial Crisis Inquiry Commission goes on, it’s getting better. It turns out that, after getting past the first few committee members, the questions improved. An interesting one came from Keith Hennessey. He asked about the banks being too big to fail. He wanted to know if a) the market assumed that these banks would be rescued by the government, due to their size and interconnectedness before the crisis and b) if the banks internally assumed that they would be rescued if something went wrong.

The reason I find this so question important is because one major criticism about the banks is that they knowingly took big risks because they assumed that the government would bail them out if anything went wrong. I’ve long thought this was incorrect, but that the banks just made really big, really bad bets — and they wouldn’t have if they had known better. Of course, too big to fail has become a problem since then, because the government has proven that it will, in fact, bail out big institutions.

The bank CEOs all responded in the same way. None of them believed that there was a market perception that any bank, no matter how large, had an implicit government guarantee. As proof, Morgan Stanley Chairman John Mack pointed to Lehman Brothers. Certainly, its fate made crystal clear that banks could fail. Its stock price plummeting in the days leading up to its failure indicated the market’s belief that failure was possible.

And Goldman Sachs CEO Lloyd Blankfein added another point. Even some of the banks that didn’t technically fail, because acquired — like Bear Sterns and Wachovia — effectively failed, with their equity becoming virtually worthless. Equity investors certainly never believed the big bank stocks would be okay no matter what. He also mentioned that their corporate debt spreads expanded substantially, indicating that bank creditors felt the same way.

When asked about internal discussions, all four denied that there was any kind of assumption ever discussed that the government would rescue their banks. Again, they pointed to Lehman as proof that they could fail. And by the way, these guys were under oath. So if an e-mail did surface indicating otherwise, they could face perjury.

Now, the question of whether it was assumed banks could fail prior to the crisis and after the Treasury’s stress tests were completed are separate issues. Hennessey also asked about whether the market views those institutions that underwent the stress tests as now being too big to fail. Their answer here was different.

Here, Blankfein responded that he believes the market perceives that the government will now intervene if any of those large banks were on the brink of failure. But he also thinks that this will change in the next few years.

That belief was underscored by Hennessey’s follow-up asking the CEOs their view of a non-bank resolution authority. Both Bank of America CEO Brian Moynihan and John Mack agreed that this regulatory goal was a good one. They join JP Morgan CEO Jamie Dimon, who has already asserted in a Washington Post op-ed that the government should make certain that firms can fail.

Other than Hennessey’s line of questioning, there were some other good inquiries made as well. Commissioner Brooklsey Born had some good questions about derivatives. All the CEOs agreed that exchanges and clearing houses would help. Dimon said that he estimated some 70% of derivatives would probably easily fit into those molds, with the rest too customized for exchanges or clearing houses.

I’m listening to the next panel now, and it’s been pretty good so far.

As I continue to watch the Financial Crisis Inquiry Commission hearing, my disappointment grows. I really hoped that this would be a productive way for to identify what went wrong and what needs to be done to reform. Unfortunately, a great deal of what’s going on here feels witch trial-esque, instead of a legitimate attempt at getting useful answers. But in the sea of accusatory questions about compensation practices and selling clients bad securities, a few of the committee members are stumbling upon some legitimate questions.

One good question was asked by Byron S. Georgiou. He asked whether it would have helped if banks were forced to always hold interests in the securities they sell, which could not be hedged. This sounds vaguely reminiscent of Congress’ current ideas of how to reform securitization. As I’ve said before, this idea wouldn’t have helped and could have negative consequences, and the bank CEOs explain why.

For starters, as Morgan Stanley’s Chairman John Mack says, banks did have skin in the game. “We did eat our own cooking, and we choked on it,” he says. That’s exactly right. There wouldn’t have been a financial crisis if the banks themselves didn’t hold billions of dollars in these so-called toxic securities. If they had been required to hold these securities, you would have seen the same result.

Goldman Sachs CEO Lloyd Blankfein says, this was not a failure of incentives, but a failure of risk management. The problem, he explains, was that people didn’t know the stuff was toxic.

Mack makes another good point: investors won’t like this idea. The SEC generally frowns on investment banks holding back a portion of the securities that they originate. Banks were subject to a lot of criticism for doing this in the late 90s during the tech boom. Investors wanted access to all of the securities and were angered when good offerings turned out to particularly benefit the banks because they held onto the securities. That hurdle could, in theory, be rethought, but it’s an interesting subtlety.

The other problem with forcing banks to hold onto securities that Mack explains is one I’ve also noted in the past. It would reduce the banks ability to do business. Now, some would celebrate that banks have limitations to their size and growth, but this would also inadvertently affect the market in adverse ways. For example, there would be a far lower securitization volume. That means auto loans, mortgages and credit cards would be more expensive for consumers. Corporations would also have a higher cost of borrowing, which would stifle innovation and growth.

I’d draw an analogy as follows: imagine if Wal-mart had to keep some skin in the game regarding the products it sold. For every 100 shirts it sold, it had to hold onto one. For every 100 toasters it sold, it had to hold onto one. Or maybe it just had to take on the risk of those products. For example, if the toaster turned out to be faulty and burned down someone’s house, then Wal-mart could be sued. That’s crazy — it isn’t Wal-mart’s fault. All it did was act as a middleman and facilitate the transaction. The lawsuit should be filed against whoever created the toaster.

The same logic should apply to securities. If a stock goes bad, then blame the company it references, not the bank that sold it. If a mortgage-backed security goes bad, then blame the mortgage originator, not the investment bank who sold the security. The idea that investment banks should be responsible for or bear the risk of all of the products they sell just seems crazy to me, for the same reason most people would agree it would be insane to hold such a standard in other industries, like retail goods and stores like Wal-mart.

Yesterday, Google announced that it was fed up with China. It had been struggling with China for quite some time, tolerating its censorship laws, due to its policy to follow the laws of whatever countries it does business in. But China has finally struck its last nerve: it is now threatening to shut down its operation in China. Most analyses that I’ve read think that would be a pretty bold move, but I’m not so sure.

Before getting into my thoughts on this topic, I want to direct your attention to a post from last night by James Fallows. He’s forgotten more about China than I know, so his analysis on the political and global implications of this event is extremely valuable. He believes that this development adds to the argument that China’s government may be entering a phase where the rest of the world views its leaders as deliberately antagonistic.

So what exactly caused Google’s anger? They had been tolerating censorship for quite some time, but something different happened recently: a new and extremely disturbing cyber attack occurred. Google’s blog explains:

In mid-December, we detected a highly sophisticated and targeted attack on our corporate infrastructure originating from China that resulted in the theft of intellectual property from Google. However, it soon became clear that what at first appeared to be solely a security incident–albeit a significant one–was something quite different.

First, this attack was not just on Google. As part of our investigation we have discovered that at least twenty other large companies from a wide range of businesses–including the Internet, finance, technology, media and chemical sectors–have been similarly targeted. We are currently in the process of notifying those companies, and we are also working with the relevant U.S. authorities.

Second, we have evidence to suggest that a primary goal of the attackers was accessing the Gmail accounts of Chinese human rights activists. Based on our investigation to date we believe their attack did not achieve that objective. Only two Gmail accounts appear to have been accessed, and that activity was limited to account information (such as the date the account was created) and subject line, rather than the content of emails themselves.

Third, as part of this investigation but independent of the attack on Google, we have discovered that the accounts of dozens of U.S.-, China- and Europe-based Gmail users who are advocates of human rights in China appear to have been routinely accessed by third parties. These accounts have not been accessed through any security breach at Google, but most likely via phishing scams or malware placed on the users’ computers.

A cynical view of this news might be that Google’s hubris caused its reaction to this attack. Once its intellectual property is at stake, it gets serious. But thinking more deeply about what the company actually says above, I think a very different conclusion should be reached.

We know that a) cyber attacks are not uncommon and b) Google had managed to tolerate China’s censorship polices up to now. The difference here is the nature of the attack. Google is infuriated, not just that its own data was compromised, but that the attack appears to have been politically motivated. What angers Google so much is that opponents of human rights are trying to gather the private information stored through Google services of those who fight for human rights.

Now Google doesn’t come out and say that the Chinese government orchestrated these attacks. But whoever did certainly doesn’t sympathize with human rights activists’ cause — and neither does the government. So, to me, this sort of looks like a situation where Google is challenging the Chinese government to take action against those who sought to violate the privacy of human rights activists. If China fails to comply with this request, then Google may exit China. The one thing it won’t tolerate is the Chinese government’s acquiescence to hackers targeting a specific group of individuals for political reasons.

From a business perspective, this shows a pretty serious dedication by Google to its ideals. It’s “don’t be evil” mantra is being upheld here, at the cost of significant revenue potential in China. It’s easy for someone like me to say that Google shouldn’t do business in a nation that has such politically unsavory policies, but I don’t have millions or billions of dollars at stake like Google does by making this decision.

I think it would be rather tragic if Google does exit the Chinese market, however. On some level that would kind of be like Google “letting the terrorists win.” If it really wishes to fight evil, as its motto indicates, then simply throwing in the towel seems like the easy way out. If Google really wants to make a statement, then it should continue to fight the good fight and use its technological prowess to make its systems impenetrable to such attacks so that its search and services can enhance the lives and knowledge of the Chinese people.

Today I’m watching the Financial Crisis Inquiry Commission hearing. So far, it’s been troubling. Its leader Phil Angelides starts his questioning with Goldman Sachs CEO Lloyd Blankfein. It’s pretty clear that Angelides simply doesn’t understand how finance works. That’s not a good indicator for anything productive coming out of this commission.

Angelides’s first line of questioning had to do with the much written about story where Goldman Sachs sold products to investors that it held a negative view of. In other words, its customer bought a security that says A will go up, and Goldman held an opposing security that said A would go down. This sounds really bad if you don’t understand finance.

But if you do understand finance, then you know it’s a zero-sum game. You can’t make a bet for something unless someone else makes a bet against something. As a market maker, Goldman creates these bets. In some cases, it sells both sides. In other cases, it holds one side of the bet. That’s literally its business as a principal.

So when Angelides uses an analogy like, “It sounds to me like you’re selling someone a car with faulty brakes and then buying an insurance policy on that car that pays you when it crashes,” he’s demonstrating that he really doesn’t understand something very fundamental about finance. You can’t be a market maker without sometimes holding a security interest in opposition to the performance of the securities that you sell to investors. And if there’s investor demand for that security, then it’s insane to blame a bank for capitalizing on that demand, no matter what its view of the performance of that security. Unless Goldman is doing something to influence the performance of the securities its sells — and it isn’t as far as we know — then it’s crazy to hold it accountable for investors making bad bets in buying the products it sells.

Yesterday, the Wall Street Journal had one of those articles that seek to make people worry, a lot. The grim picture it paints is not one of a job market that will just be slow to recover — it claims that some Americans’ occupations may be lost forever (shudder!). It worries that some jobs that were lost during the recession may never come back. While certainly true on a sort of practical basis (if a firm goes under, its jobs are lost forever), the article argues a graver point: that the job market is changed forever.

That’s rubbish. The recession didn’t cause a sort of structural job shift that might have resulted from, say, a major technological innovation. It just created severe cyclical job losses in several specific industries. And while it might take a very long time for those job numbers to return to their pre-recession level, they will get back to a healthy level eventually.

Let’s consider what the WSJ says:

The downturn that started in December 2007 delivered a body blow to U.S. workers. In two years, the economy shed 7.2 million jobs, pushing the jobless rate from 5% to 10%, according to the Labor Department. The severity of the recession is reshaping the labor market. Some lost jobs will come back. But some are gone forever, going the way of typewriter repairmen and streetcar operators.

Oh c’mon. What industries were completely obliterated? I can’t think of a single one, though some were severely debilitated, and will take a while to reconstruct. Here are the sectors the WSJ mentions:

Many of the jobs created by the booms in the housing and credit markets, for example, have likely been permanently erased by the subsequent bust.

It later singles out construction. So did construction jobs go “the way of the typewriter repairmen and streetcar operators?” Unless I missed news about a new army of robots that now construct homes and office buildings, then of course not. The construction industry definitely suffered extraordinary job losses. Given the enormous excess inventory of housing and commercial real estate the bubble caused, I doubt those jobs will come back anytime soon. But they will come back eventually.

At some point, probably years down the road, the home and building inventories will begin to dwindle. Old construction will need more repairing, and population growth will demand additional housing, factories and office buildings. At that time, you’ll see construction jobs grow again. They’re hardly gone forever.

The same could be said for credit markets. True, you might not have as many little mortgage companies and shady mortgage brokers popping up around Southern California as there were pre-recession. But people will continue to need mortgages one way or another. Those jobs will just be for mortgage underwriters at good, old fashioned banks instead of subprime mortgages shops. Again, credit markets aren’t suddenly gone forever. Even securitization may rise again — unless regulation kills it.

I don’t mean to minimize the seriousness of the employment situation. It’s a major problem, particularly given how long it will likely take to get back to anywhere close to full employment. But I don’t buy into alarmist articles like this one from the WSJ, which simply exaggerate reality just to scare their readers.

Back in September, I wrote about the proliferation of in-flight Wi-Fi on commercial jets. At that time, I explained how I thought the airlines must be thinking about how to make offering Internet to customers profitable. I suggested a sort of Internet café approach, where airlines could maximize customer demand by customizing the purchase price to consumer need. Of course, they would lose some money on those willing to pay more who end up using less time. But I still think they would benefit most by maximizing users. So far, however, they continue to prefer a flat-rate approach.

Today, another wrinkle emerges on this topic, as the New York Times explains a new strategy by Continental. It’s trying a little experiment. The results could shape the future of in-flight Internet and entertainment.

The Times reports:

In mid-December, Continental Airlines made a move that further clouded the picture. Continental, which had lagged competitors in embracing in-flight Wi-Fi, announced that it would install Gogo on its fleet of 21 Boeing 757-300 aircraft early this year.

But at the same time, Continental indicated that it was hedging its bets. Continental has also been installing a live in-flight television system, which is now available on 48 of its later-model 737s and is planned for its 757-300s by the end of the first quarter. Those are the same 757s, incidentally, where Continental has decided to install Gogo Wi-Fi.

Continental says it is experimenting with the market. The television system DirecTV offers 95 channels of live television and eight programmed channels, for about $6 a flight. (It is free in first class.)

The DirecTV system also offers a service — free to everyone — called Kiteline, which uses a tiny slice of the broadband spectrum for passengers to send and receive e-mail messages and instant messages. This bare-bones connection does not allow surfing of the Web. But it is free, whereas Gogo’s full-broadband service is not.

Continental’s question is, Will passengers who already have the option of watching television pay for a full broadband connection, or will they be satisfied with the limits of a free e-mail connection?

In other words, would you rather have DirecTV + e-mail for $6 or full Internet (including e-mail) for $5 or more, depending on the duration of the flight? For shorter flights Internet might be a dollar cheaper, but on longer flights it could be more expensive than DirecTV + e-mail.

In a sense, readers have already answered the question of how much consumers are willing to spend on Wi-Fi. Back when I wrote that post in September, I created a poll asking people how much they’d pay for in-flight Internet. Here are those results:

As you can see, a majority of people (56%) said they’d only be willing to pay between $4 and $6. Perhaps Continental took a poll with similar results to arrive at their minimum of $4.95! Meanwhile, only 5% said they’d pay more than $10. So, if I were an airline, I certainly wouldn’t charge more than $10, if I chose to offer a fixed rate plan.

But what does this mean for Continental’s current experiment? That I’d be pretty surprised if its fliers didn’t choose DirecTV + e-mail more often than Internet, which I take to be more expensive on most longer flights when Wi-Fi entertainment would be more important to jetsetters. If they key is to kill time and keep in touch with people in case anything comes up, then DirecTV + e-mail accomplishes that pretty well, though Wi-Fi would allow more freedom and entertainment options.

Which populations of travelers would choose each of these options? I think that could have a surprising outcome. Intuitively, it might seem like business fliers would be more willing to spend more money on in-flight connectivity, so to get more work done while on the plane. That may be true, but it may not be — if they can access their e-mail through the DirecTV component, I’m not sure many would care about additional Internet connectivity. Besides, business fliers might not be willing to pay a premium for full Internet access if their travel expense budgets are feeling the squeeze.

Leisure flyers, on the other hand, might want Wi-Fi. They could potentially be more interested to get the most for their money and enjoy Internet news sites, social networking sites and e-mail access — not to mention access for their iPhones, Droids, Nexus Ones and other smartphones. Additionally, if the Wi-Fi connection has a decent signal, then these fliers could even watch TV or movies on their laptops through services like Hulu or Netflix anyway. Who needs DirecTV?

Ideally, airlines would offer both options. But I’d imagine that would be a lot more expensive than just offering one or the other. So I suspect eventually Continental will drop one, once it figures out which travelers prefer. And since the Wi-Fi poll did so well, let’s answer this question too. Vote below!

Last month, I wrote about a growing real estate bubble in China and pondered how the Chinese government would respond. In recent weeks we’re starting to get a glimpse of its springing to action. Its latest moves are more aggressive: it has increased the commercial banks’ reserve requirements and raised rates on government debt to make it more attractive to investors. These actions contract monetary supply and should help to slow its wild economic growth, but just a little. It appears to be a smart move.

Increasing banks’ reserve requirements essentially constrains their lending. The higher the reserve requirement, the more of a bank’s capital is forbidden from being used to make new loans. With less money to lend, less credit is available, and monetary supply contracts. The Wall Street Journal reports:

Starting next Monday, most commercial banks will be required to put 16% of their deposits on reserve and not lend the money, an increase of a half percentage point. In recent years, that reserve requirement rate has emerged as a primary tool for the central bank to fine tune monetary policy.

A half point isn’t drastic, but also isn’t insignificant. Usually, when central banks raise rates, they do so gradually. So this step is meaningful, not so much because of its magnitude, but because of the signals it sends: China is worried about excess monetary supply and is beginning to apply a strategy to rein it in. And that’s not all:

Also on Tuesday, the central bank raised the yield it pays on its one-year bills, a move also designed to siphon cash out of the financial system by making the debt securities more attractive for banks to buy.

By making this debt more attractive, investor will shift more money into the less risky assets. That takes money out of the credit markets and freezes it in government bonds. Again, monetary supply declines.

Central bank moves like this are always highly contentious. For example, if the U.S. Federal Reserve did this kind of thing right now, then that could be extremely dangerous: contracting monetary supply at a time when an economy is struggling to recover from a deep recession could throw it back into the trough. But China’s economy is in much better shape right now that the U.S.’s economy. Its real estate prices are appreciating; it’s receiving a lot of foreign investment; and its exports appear to have recovered. So while it’s impossible to know if the central bank’s timing was perfect, there’s definitely a strong argument that its move makes sense.

In fact, it seems particularly warranted in light of the real estate bubble that I mentioned last month. One of the criticisms of the U.S. Fed is that it failed to draw in monetary supply during the housing boom, causing the real estate market to overheat. Clearly, China doesn’t want to repeat our mistakes.

The other fear, of course, is inflation. China wants to ensure it isn’t a problem. The WSJ says:

At this point, inflation is under control, although the consumer price index turned positive for the first time in November and rumors are widespread the December number will show a jump.

Economists say headline inflation rates in China are likely to rise rapidly in the next few months, even if only because current prices are being compared to the extremely-depressed levels of early 2009.

Again, in light of that, tightening credit makes a lot of sense.

As usual, investors will be less than amused by this monetary restraint. When a central bank decides to take action like this, it usually means that the party is over for the bulls. So look for Chinese equities to take a hit when the market opens (the announcement was made after market close yesterday). But don’t take the market’s reaction to be a meaningful verdict on whether the central bank’s move was wise — just reflective of its crankiness that it probably can’t expect as irrationally high returns through 2010 from investment in China if its central bank continues down this path.

The Federal Reserve reaped quite a nice reward for its rescue efforts during the financial crisis. According to its preliminary unaudited 2009 results, the central bank made a whopping $52.1 billion in profit. Somewhere, Ron Paul’s blood is boiling. But before populist outrage at these profits take hold, let’s consider a few things.

First, the vast, vast majority of these profits are going back to taxpayers — $46.1 billion. As the release says:

Under the Board’s policy, the Reserve Banks are required to transfer their net income to the U.S. Treasury after providing for the payment of statutory dividends to member banks and equating surplus to paid-in capital.

Those statutory dividends were $1.4 billion, while the surplus capital was $4.6 billion. Taxpayers get the rest.

So the first point is that taxpayers actually benefit from the Fed’s profits. A lot. They got 89% of its net income. As a taxpayer, I’m pretty happy about that.

Now how did the Fed manage to do so well? Well, at the end of the day, the Fed is just a bank. And if you read much business news in 2009, then you know that it was a pretty good year for banks. In late 2008 and early 2009, when most of the Fed’s intervention took place, assets were traded at very low prices. Since then, many of those assets’ prices have increased. Thus, a lot of those assets that the Fed purchased appreciated substantially in value during 2009. And the Fed had bought a lot of assets through its rescue efforts.

I’ll be curious, however, to see the Fed’s full financial statements, which have not yet been released. I’d be interested to know which types of securities, specifically had the biggest gains. It must have had some losses on the assets it purchased, so the gains from other assets must have been quite substantial to wipe out those losses and still result in such a healthy profit overall.

Lastly, I wonder what the Treasury will do with a cool $46 billion? Will it reduce the deficit? Put it towards a jobs stimulus program? Lower the amount of money it plans on forcing banks to pay in the form of a putative tax? Or maybe just squander it.

Today in the New York Times, Andrew Ross Sorkin has a fun column consisting of a list of questions that he would like to hear the Financial Crisis Inquiry Commission ask when it convenes tomorrow. He believes the questions would “help start some lively discussions.” He’s right, because the questions he lists are virtually all accusatory in nature towards the Wall Street bank CEOs who will be testifying. So while amusing, I think the commission would be prudent to consider more questions that are actually productive to its mission of better understanding “the causes and current state of the crisis.” As a result, I thought I’d offer a few suggestions of my own, just in case anyone on the committee happens to be reading.

Before getting into my own, let me give an example of the kind of questions Sorkin poses:

A question for all the executives about bonuses: We keep hearing that you plan to pay out billions in bonuses this year. Given that they come out of profits that, to a large degree, seem to be the result of government programs to prop up and stimulate the banking sector, do you think they are deserved, even if they are in stock? And, while we’re on the topic, given the market crisis of 2008, were you all overpaid in 2007?

For starters, bonuses had very little to do with what actually caused the crisis. Even if they were substantially lower in 2007, the bankers would not have behaved differently. They would have still sought the highest profit possible, because that’s what bankers do. The CEOs would likely respond that there were some divisions that did not perform well (MBS traders, for example), and their bonuses (and layoffs) will reflect that, but the majority of their employees performed at or better than expectations (M&A, corporate debt underwriters, etc.). Unfortunately, in this case, a few bad apples spoiled the bunch.

So rather than ask questions to purposely put these CEOs on the defensive, and produce no significant answers to actually help the reform effort, I’d suggest the following instead:

Imagine it’s 2005. You can change three decisions you made and alter the future. What are those three things that you would have done differently?

What do you believe the Federal Reserve could have done differently to prevent or lessen the severity of the crisis? Did it have the tools necessary at the time to do so, or was it incapable due to a lack of authority?

A popular regulatory goal of Washington is bank regulator consolidation. Would it make your job easier or more difficult to have to answer to one bank regulator, instead of several? Do you think this would harm or benefit the market?

Many have argued that capital and leverage levels weren’t prudent enough, which is part of what forced the government to recapitalize your banks with a bailout. How high would your capital levels have needed to be to avoid the crisis? What maximum leverage limit would have accomplished the same result?

One of the most significant regulatory proposals would be the creation of a non-bank resolution authority. The idea would be that, if something like the crisis happened again, a firm like AIG could be more neatly wound down. Do you believe it’s actually possible to resolve large, interconnected firms like AIG and your banks without causing economic crises in the process?

It’s been suggested that one way of accomplishing neat resolution of complex entities would be to require those firms to submit failure plans to be followed in a default event. If you had to draw up such a plan currently, could you do so with the confidence that the plan could be executed without causing a major economic disturbance?

What are your views on Fannie and Freddie? Is it a good idea from an economic perspective to have an entity with an implicit government guarantee to insure and purchase mortgages? What should the government’s role be going forward when it comes to mortgages?

Some believe that option adjustable-rate mortgages are financial instruments of destruction for consumers. Can you explain why dangerous, misleading consumer financial products should remain legal?

If independent financial research firms were to take on the responsibility of evaluating bonds, instead of the rating agencies, how would that change the market? Would investors be able to function without rating agencies? Do you believe during the crisis they were too reliant on the rating agencies without doing enough of their own due diligence?

All of Washington’s financial regulation proposals would force securitizers to keep some skin in the game, requiring them to retain a portion of the risk in the pools they create asset-backed bonds out of to sell to investors. How would that change the securitization market as we know it? How would that, in turn, affect consumer lending?

Explain the role that derivatives played in the crisis. What might have helped prevent the problems they created?

Justin Fox at Time considers the possibility. He believes that the government’s decision to increase its issuance of inflation-protected Treasuries could prevent it from inflating away its debt, though he has some doubts. So do I.

On one hand, Fox’s logic can’t really be disputed:

With the total U.S. government debt held by the public at $7.8 trillion as of last week, $600 billion is still small beans. But if the TIPS share grows, it will get harder and harder for our U.S. government to inflate its way out of its burgeoning debt burden. That is, if all a country debt is in fixed rate bonds (as was the case for the U.S. before 1997), inflation shrinks the size of that debt relative to the overall economy and, more to the point, tax revenue. If all the debt were in inflation-linked bonds, inflation wouldn’t reduce the debt load at all.

But, as Fox notes, there’s a big “if” in there. Right now TIPS are still a relatively minor portion of total outstanding debt. It would likely take quite a few years and a significant change in the portion of inflation-protected debt issued for this point to matter. Unless the TIPS portion of outstanding debt grows much larger, then the government would still benefit from allowing inflation to devalue the rest of its unprotected debt. So, in the near-term (read: next 3-5 years) I don’t really see TIPS acting as a major barrier to inflation, if that’s really what the government has in mind.

And as Fox also touches on, the TIPS obstacle could be an easy one to get past for the government anyway. After all, it defines the inflation rate that TIPS’ yield depends on. If Washington was really motivated to use inflation as a tool, it would make sure that whoever was running the Bureau of Labor Statistics provided a consumer price index calculation that skewed the official inflation reading in its favor.

With that said, I don’t think a conspiracy of such proportions is likely. The best way for the U.S. to get itself into a whole lot of trouble would be for it to render its debt worthless with extreme tactics like this. Surely, policymakers realize that. So the real fear — that of hyperinflation — is probably exaggerated, with or without TIPS. If policymakers are willing to alienate investors to that extent, they’ll just stop buying U.S. debt. And the prospect of the U.S. going into default would be far worse than feeling forced to actually keep up with its debt obligations.

In the U.S. our housing market has been pretty bad over the past few years. But take heart America: at least you’re not Dubai. Sure it hasn’t had any foreclosures up to now, but that’s only because the laws there have made it difficult for banks to seize property. In fact, reading a report today from Bloomberg, things are far worse for housing in Dubai, and a tidal wave of foreclosures may be set to break.

Bloomberg explains:

Dubai’s housing rout sent prices down 52 percent in the past year, prompting some homeowners to abandon their cars and mortgage payments and flee the country. Not one received a foreclosure notice.

Until now.

Barclays Plc won the sheikdom’s first foreclosure cases in court, clearing the way for lenders holding about $16 billion of Dubai home loans to take action when borrowers don’t pay. Islamic lender Tamweel PJSC, the emirate’s biggest mortgage bank, has several of its own foreclosure claims pending and estimates about 3 percent of its mortgages are in default.

That situation looks a great deal worse than what the U.S. has been dealing with after the housing bubble popped. And it should be: speculation fueled Dubai’s housing bubble to an even greater extent than it did in the U.S.

But even though Moodys expects around 12% of residential mortgages in Dubai to default by the first quarter of 2011, that’s only out of 27,000 total mortgages. That amounts to a mere 3,240 foreclosures. So as bad as this news sounds, given how small those numbers are, the banks involved may have a relatively easy time cleaning up the mess, compared to the millions of foreclosures in the U.S. To put that number in perspective, Palm Beach County, Florida had more foreclosure than that (3,321) in November 2009 alone.

In the latest installment of the Big Think’s “What Went Wrong” series, Chrystia Freeland, the Financial Times’ U.S. Managing Editor addresses whether better business journalism could have prevented the crisis. She doesn’t think so. She says nothing could have prevented the crisis. That may be true, but I believe it could definitely have helped matters. And she appears to agree that business journalists could have been better by being more eager to tackle complex problems, questioning the consensus point of view, and not getting as caught up in market optimism. I agree and think it’s worth expanding on these points.

Business Knowledge And Understanding

Part of the reason I got into business journalism is because I was tired of reading so much terrible, uninformed reporting on finance and economics. So I completely agree that no business reporter can succeed if he or she lacks an ability or willingness to tackle complex problems. Business news, more like any other kind of news, requires a solid understanding of what you’re reporting on. You also have to be able to perform analysis, because lots of numbers are involved. If you can’t navigate your way through a spreadsheet, then you’re going to have trouble effectively covering business and finance.

That doesn’t mean you need to have worked in the market before becoming a business journalist, though it might help. It is possible to develop the knowledge as you go. A perfect example would be the New York Times’ Andrew Ross Sorkin, who I consider to be a top-notch finance reporter. In another interview posted this week as part of the Big Think Project, he notes separately one of the reasons why he has had so much success covering Wall Street:

I’ve tried to study the industry. I’ve spent enormous amounts of time. I can, unfortunately, do a model, a DCF model, with the best of them. I wouldn’t say I enjoy it, but — and I also think that when you’ve studied it up, when you’ve come to the table with the right questions, when it’s clear to the other side, the interviewee, that you know what you’re talking about, you can get a lot more.

Consensus, Optimism and Wackos

Then, there’s consensus and optimism. I think these points really mesh together, and I’ll explain why in what follows.

I’ve noticed the vast, vast majority of business news coverage can be grouped neatly into two categories: arguments for the consensus and arguments by wackos. There’s very, very little voice given to those who wish to thoughtfully challenge the prevailing views in the market. Why is this?

First, I have noticed a sort of strange difference between business news and other news. When it comes to general news, lots of people complain that journalists only focus on the bad news, while rarely doing stories on good news. That’s because good news doesn’t get eyeballs. Which headline’s story do you think more people will read: “Local Man Named Teacher Of The Year” or “Local Man Murders Entire Family”?

But with business news, it’s sort of the opposite. The business community likes reporting that accentuates the positive. It’s almost as though many of those in business like their news to make them feel better. Maybe they want their egos stroked to believe their stock portfolios are safe. Most of this community wants the news they consume to reflect market optimism.

And that makes sense, because business news can affect the market. In the rare event that legitimate business news hits with a negative view of a company, then people can lose money. Since far more market participants are long stocks, instead of short, pessimism can actually cause tangible harm. That’s why the consensus — which tends to be optimistic — is a touchy thing to buck for some news outlets.

Of course, there are news reports that do disregard the consensus views. But they’re most often the wackos. These are the nut jobs calling for Zimbabwean inflation in 2010. They’re the crazies worrying about the U.S. defaulting in the next two years. Business viewers don’t find these guys harmful, however, because few take them seriously. Sure, there’s a handful of people who might heed these wacky warnings, but most of the business community finds them an amusing diversion and feels they pose little risk to the general consensus. News outlets love them too, because they’re generally amusing guests to watch or hear from. As reality TV’s success has proven: people love watching crazy.

Does that mean that business journalists can’t question the consensus views in a thoughtful manner? Not exactly, but it does mean that there’s a risk in doing so. Some media outlets would be okay with that; others might not. While investigative reporting that reveals the facts, whether positive or negative, is desirable from a journalistic perspective, the reality is that media needs readers to pay the bills. Those goals don’t always coincide.

But I have always lived by some advice given by Mark Twain in one of my favorite quotes of his, and think business journalists should too:

Whenever you find yourself on the side of the majority, it is time to pause and reflect.

I believe one of the most important things that a business journalist can do is look at the prevailing views in an economy and question them. Anyone who wants to learn something from reading what you write doesn’t need to hear what they already know and believe — they need to learn something new. If you turn up some data or logic that goes against a commonly held market view, then that could be incredibly useful. If business reporters really embraced this philosophy, then perhaps business readers would realize the value that could be derived by good journalism.

Friday, I reported that the U.S. employment situation is murky at best, with 85,000 more jobs lost in December and jobless Americans becoming more discouraged. But many of those having trouble finding a job could be in for a stroke of good luck: it’s a census year. That means over a million temporary workers will be hired in the first half of this year to count Americans. A recent article from Bloomberg argues that this hiring could jumpstart an employment rebound. I doubt it.

First, this work may, indeed, serve as a sort of “bridge” for those who get the census jobs. Perhaps after being employed in that capacity for some months, the economy will have improved. That way, we’ll have fewer people on unemployment during that time, and when they hit the job market again, it may have improved slightly.

Yet, I disagree with Bloomberg when it says:

Money earned by the clipboard-toting workers going door-to-door to verify the government population survey is likely to be spent, giving the economy an extra lift.

“It’s a short-term stimulus program in which the government’s injecting money into the economy through additional paychecks,” said Dean Maki, chief U.S. economist at Barclays Capital Inc. in New York, who projects that 2.5 million more Americans will be working at the end of the year. “This will support consumer income during those months.”

I have trouble understanding why these jobs would do anything on their own to actually improve the economy. The lion’s share of these temporary workers will likely leave their unemployment checks behind to collect a paycheck from the U.S. Census Bureau instead. In other words, Uncle Sam will just be handing them money from a different pocket. And unless these jobs are surprisingly lucrative, I doubt he’ll be handing them a whole lot more money than most of them were collecting on unemployment anyway.

As a result, we won’t really see more spending as a result of temporary census jobs. Indeed, anyone who has these jobs will still be especially cautious about opening his or her wallet, since these jobs are temporary by nature. These workers will probably want to save whatever they can, because once these jobs end, they’ll be thrust back into an awful job market.

What’s worse, these jobs are utterly unproductive. These aren’t manufacturing jobs where these individuals are creating products to be sold overseas. They’re not infrastructure jobs that will improve roads and make commerce more efficient. They’re not even construction jobs to weatherize homes and help drive down U.S. energy costs. These workers will be walking from door to door and taking a count. Nothing will be produced except for some statistics, with no direct economic value.

Finally, census work might be better than no work, but that’s all it’s better than. These are likely jobs that will contribute very little to most of these individuals’ skill sets and career development. That means, other than perhaps timing, they’ll likely be in no better position to get a good job after the census ends than they were beforehand.

So are temporary census jobs better than nothing? Sure. But I see no reason to believe they’ll have any kind of stimulating effect on the economy.

Economist Simon Johnson has a post today on his Baseline blog calling for a supertax on banker bonuses in the U.S. Great Britain and France have created such excise taxes, though Johnson wants a U.S. version to directly fall on individual bankers’ shoulders. I hate to harp on the same point again and again, but as I wrote on Friday, attacking compensation fails to directly address or solve the real problem: systemic risk.

If you’re on board with Johnson’s assumptions, his arguments make sense. His rejoinders to the common criticisms of a banker tax employ pretty simple logic: who cares if talent leaves the big banks — all the better for systemic risk; the cash from these bonuses isn’t rightfully the banks’, as the bailouts made that revenue possible; and such a tax might seem incredibly drastic, but unreasonable actions (paying huge bonuses now) call for unreasonable responses (taxing them accordingly).

So imagine that the U.S. collects this tax. Let’s say it’s worth $10 billion per year. That a lot of money. What does Uncle Sam do with it? Use it to pay for healthcare? For the wars in the Middle East? For a future bailout fund? Herein lies the problem with a punitive excise tax: the government gets to spend the money as it pleases, which may or may not coincide with the actual problem it’s created to address. In this case, that’s bank risk.

Given the ridiculous level of national debt the U.S. has incurred up to now, additional tax revenue might not sound too bad, even if Congres does use the money as it pleases. But for any supertax to have any chance of actually alleviating the problem it’s meant to correct, then that revenue must be placed, and left, in a superfund for the Treasury to pay for future financial crises. I find it hard to believe that Congress would let that happen. Given all of its many other priorities, the idea that it would really isolate all that cash from its general fund seems unlikely.

And to reiterate my point from Friday, I also think it needlessly involves the government too deeply into the business of deciding what people should be paid. If you ensure that these institutions will be stable, then you don’t have to bother taxing compensation: their employees can be paid whatever they like without threatening the U.S. economy. And again, the way you do that is through higher capital and lower leverage levels. That takes care of the compensation problem, since these firms will have fewer profits to distribute to their bankers and traders.

I fully understand the outrage many feel about bank employees again collecting billions in bonuses as the rest of the economy continues to struggle — after taxpayers saved the very firms distributing that cash. But that populist anger isn’t reason to disregard sensible policy. Washington should focus on ensuring a more stable financial system and more reasonable compensation levels will necessarily follow.

Last week, I wrote about the AIG-New York Federal Reserve bank swap controversy. At that time, I speculated that it could be a problem for Treasury Secretary Timothy Geithner, given that he resided over the NY Fed at the time. Today, Bloomberg reports that powerful Democrats are standing behind Geithner. I find this quick support a little surprising and premature. Shouldn’t Democrats wait to better investigate the situation before drawing a conclusion about Geithner’s innocence?

Bloomberg says virtually every Democrat in a prominent place of power has Geithner’s back:

Asked yesterday for comment, White House Press Secretary Robert Gibbs said he stood by his earlier statements that the president had full confidence in Geithner. Jim Manley, a spokesman for Senate Majority Leader Harry Reid of Nevada, said “Secretary Geithner enjoys the strong support of the Senate Democratic caucus.”

. . . he maintains the backing of Democratic leaders including Representative Barney Frank, House and Senate Democratic aides said in interviews Jan. 8.

So what might change that? According to the article:

Only a revelation that he was directly involved would erode that support, a Senate Democratic aide said on condition of anonymity.

And here’s what they’re saying his role consisted of:

The Obama administration and the New York Fed came to Geithner’s defense, saying he had nothing to do with the e-mail exchange between lawyers for AIG and the district bank. Treasury spokeswoman Meg Reilly said that Geithner was already recused from AIG matters when the e-mails were written.

Now listen: Geithner may now have written the e-mails, but are we really to believe that, as President of the NY Fed, he shouldn’t have been expected to run a tight ship? Should we take comfort in the fact that he ran an organization where this kind of thing could happen — and now he runs the U.S. Treasury? I know I don’t. That’s why I don’t particularly care if he wrote the e-mails himself, but I think it’s more telling that this kind of thing could happen under his watch.

Of course, at the end of the day, this is just politics:

Geithner’s role as the administration’s point man on overhauling financial-industry regulation makes him more of an asset than a liability on Obama’s team as the November midterm elections approach, said former congressional aide Charles Gabriel, managing director at Capital Alpha Partners LLC, a Washington-based firm that provides research to institutional investors.

I agree that this is probably the thinking. If Democrats suddenly shunned Geithner, that would cast a very dark shadow over financial regulation. After all, the House bill — which is likely to closely resemble whatever eventually passes — was essentially created from the Treasury’s, i.e. Geithner’s, framework. If Democrats reveal doubt about Geithner’s character or ability to discern what’s right for the financial industry, then Republicans would surely connect the dots to their financial regulation proposal.

Yet, I’m not as convinced as Gabriel that this is smart politics. Geithner’s presence could still harm the financial regulation push if more moderate or fringe Democrats in Congress are angered by his association. Moreover, by keeping Geithner around, Republicans will have a delightful time during the midterm elections explaining how the Obama administration and Democrats in Congress cater to more business as usual when it comes to Wall Street — just look at their Treasury Secretary!

So I’m not entirely convinced that Democrats’ “support first, ask questions later” policy makes a whole lot of sense from a practical or political standpoint. As the President of the NY Fed, if the buck doesn’t stop with Geithner, with whom does it stop?

Here’s a fun one: Goldman Sachs may require its mostly highly compensated employees to donate a portion of their pay to charity. Could the firm the American public views as a “great vampire squid wrapped around the face of humanity” be growing a heart? The New York Times reports that the talks for creating such a policy are still ongoing, but it could happen. Yet, to me this looks a lot more like a very transparent public relations campaign to quell populist outrage than the bank really feeling it should give back, which means that the firm kind of misses the point.

First, the NY Times explains that this isn’t the first time a big bank would institute a rule mandating charitable giving:

The charity idea would be similar to a decades-long program at the failed investment bank Bear Stearns, which required more than 1,000 of its top workers to give 4 percent of their pay to charity each year and then checked their tax returns to ensure compliance.

Because when I think about a firm I’d want to emulate, I think of Bear Sterns. Obviously the program must not be meant to enhance the stability of the firm or the prudence of its bankers and traders.

My first question is: why would only “executives and top managers” be required to participate? Sure, they’re the ones making tens and hundreds of millions, instead of seven measly figures, but pretty much every Goldman employee can afford to give a little something back. That only the richest of its bankers would need to comply with this new rule shows just how shallow an effort it really would be.

Second, I bet I can guess who wouldn’t be a fan of this program: local and federal governments. More charity by these high earners means more tax deductions and less revenue for Uncle Sam. If Goldman does institute this policy, government official should pray that the rest of Wall Street doesn’t follow.

I also wonder how shareholders will feel about this proposal. They might prefer if that money was set aside for bigger dividends instead of soup kitchens. This would still accomplish some good PR, with smaller bonus levels, but still keep the earnings in the family, so to speak.

Even though these bankers and traders could surely afford a required charitable contribution, I find it a little creepy to require someone to be generous. Sure, it would benefit charities out there, which would presumably put that money to good use. But the idea of requiring people to give to others feels a little too much like a company pushing its morals upon its employees. Of course, you could argue that’s what the government does through taxes too….

It also, ultimately, fails to address why so many Americans hate Goldman. By forcing its employees to give chunks of their compensation to charity, the firm merely reinforces what everybody thought: that its bankers and traders are greedy scoundrels, clutching onto their dollars like Scrooge McDuck. As a result, I think that such a policy could almost be counterproductive from a PR standpoint.

Yet, I’d be willing to bet that Goldman employees already give tens or even hundred of millions of dollars to charity each year. Instead, why not just continue to softly urge Goldman employees to be charitable and make sure they’re well aware of lots of options to make giving logistically simple. Then the firm could document that giving and let the world know how generous its bankers really are, without coercion.

Despite the fact that all the big banks have paid back their bailout, many policymakers are still concerned about outlandish banker compensation. One interesting suggestion has been made by the Federal Deposit Insurance Corporation. Maybe if it deems a bank’s compensation scheme as too risky, i.e. giving employees too much earnings and not holding onto enough earnings to use as cushion for unforeseen disasters, then it could charge the bank more for its depository insurance. It will vote on the plan next week. While clever, I still think stricter leverage and capital requirements are a better way to deal with bank risk and compensation.

I read about this suggestion in an article from Breakingviews.com. It explains the rationale:

Generating the most buzz is a sensible plan to tie the amount that banks pay for deposit insurance to the risk in their compensation plans. Banks with plans that favor short-term gains would pay more than those that, for example, include multiyear clawbacks on bonuses.

That could work. But I worry that this slick plan kind of misses the real problem: actually preventing banks from running out of cash in the first place.

As I’ve said before, regulators would be better off focusing on more prudent leverage and capital requirements for banks. That way, the probability that banks would get into trouble in the first place would be lower. This would also cover investment banks, which the FDIC plan wouldn’t, since they don’t have deposit insurance.

And as I’ve also mentioned before, more conservative capital and leverage requirements would also limit compensation by their very nature. One of the reasons why investment banks are able to make so much money is because they have so much leverage. For example, if you can make $5 profit by only holding $10 of capital, that’s a 50% return. If you need to hold $20 of capital, then your return is only 25%. As a result, bank employees will be forced to make less money, since more of its revenue must go towards its capital base as its assets increase.

So I think the compensation problem will take care of itself if leverage and capital requirements are reformed. Then you don’t have to worry about any tricky regulatory measures to control how compensation is paid by charging more for deposit insurance. I favor ensuring we have more stable financial institutions that consequently can’t help but have more down-to-earth pay scales, rather than attempting to back into stability by forcing banks’ hands through dictating how they should compensate their employees.