Author: Daniel Indiviglio

The Republicans may have some legitimate concerns about Democrats’ financial reform bill, but their reported alternative has some problem of its own. The Wall Street Journal’s Real Time Economics blog has obtained a 20-page summary of the Republican plan. It eliminates the concerns Republicans have, some of which include the controversial resolution fund, forcing banks to spin off their derivatives business, and a too powerful consumer protection agency. While some of their ideas are good, others need a little more thought. Here are some highlights.

The Good

GSEs

Perhaps the most sensible move by Republicans is to add in some oversight and regulation for Fannie Mae and Freddie Mac. Virtually everyone agrees these government-sponsored entities played a pivotal role in the crisis, as they were the biggest bailout recipients. Yet Democrats’ financial reform proposals completely fail to address these troubled firms.

Financial Stability

The Democrat bill would create a list of systemically regulated firms. This remains an area of contention, because Republicans worry that these firms will be seen as too big to fail and receive a special competitive advantage in the market as a result. The Republicans appear to create a similar systemic risk regulator to watch over the economy, but without the list of firms.

Derivatives

The Republican bill almost certainly wouldn’t require banks to spin off their derivatives desks, though this isn’t explicit in the WSJ highlights. As long as banks remain in the business, the derivatives industry will be much more stable. Their large capital bases will provide for a safer market.

The Bad

Resolution

Republicans identified a legitimate problem with the Democrats’ proposed resolution fund used to wind down large firms. The right believes that it would provide an advantage to those firms, since their creditors and/or counterparties would be more willing to do business with them, due to their access to these funds through failure. Yet, here is the Republicans’ strange alternative:

The FDIC would be able to advance funds to creditors, but it would have to recoup from creditors any money a creditor received in excess of what it would have gotten in bankruptcy.

That sounds great in theory, but in practice — what happens if those creditors can’t pay back the FDIC? One can only imagine that the cost falls on the shoulders of taxpayers. Even though the Democrats’ resolution fund has some problems, at least taxpayers would be left out of it.

Fed

The Republicans want greater Fed oversight. That’s not necessarily bad — so long as it doesn’t interfere with the Fed’s independence. But it also looks like the Republicans want to limit the Fed’s ability to stabilize the financial markets. That’s inadvisable. Without the Fed’s ability to calm markets and restore liquidity, the financial crisis would have been much, much worse.

Derivatives

Yes, this was just listed as a good idea. But it isn’t all good. Republicans appear to fall prey to the same misconception about derivatives as Democrats. They intended to allow for clearing exemptions as regulators see fit. That’s good. What’s not good is that they continue worry about the distinction between “swap participants” (think speculator/investor) and “end users” (think farmer or other non-speculators), saying the latter doesn’t need to clear its derivative exposure or maintain collateral requirements. Yet, more often than not, these two kinds of parties are on either side of a derivatives transaction. Does only one side need to clear? How much will that screw up netting for the clearinghouse? And why shouldn’t non-bank firms be forced to put up collateral? If they run into financial trouble, they could also default on their derivatives obligation.

In a perfect world, Congress will reconcile Republicans’ good ideas with the smart ones that Democrats have already offered. That might happen to some extent, as it appears that Democrats will have to make concessions to get to 60 votes, after failing for the past two days to pass a test vote. How much they’ll give, however, is hard to say. Clearly Republicans won’t get all of what they want, but they might get some of it. Both sides of the aisle know financial reform must pass. Let’s just hope Democrats incorporate Republicans’ good ideas and not their bad ones.

Update: Just found the full summary text here.

There’s one thing Democrats and Republicans can agree on: their hatred of Goldman Sachs.

That fact couldn’t have been clearer through the nearly 11 hours of testimony yesterday when a Senate subcommittee aggressively questioned past and present Goldman bankers. Senators from Carl Levin (D-MI) to Susan Collins (R-ME) to Claire McCaskill (D-MO) to John McCain (R-AZ) all angrily censured these executives for their role in the financial crisis. The hearing amounted to little more than a modern-day witch trial.

Did Goldman Sachs play a part in inflating the housing bubble? Absolutely. But so did JP Morgan, Citigroup, Morgan Stanley, Lehman Brothers, Wells Fargo, Wachovia, and every other bank involved in the mortgage business. So did the rating agencies, foolish investors, Fannie Mae, Freddie Mac, Congress, the Federal Reserve, the Treasury, the SEC, mortgage brokers, house flippers, and dozens of other actors. To be fair, some of those parties have been grilled by Congress as well, but none were the subject of a singular hearing lasting half a day that contained so much anger and even some vulgarity.

But maybe Goldman deserves it. They did, after all, come out a lot better than most banks, due to their earlier recognition of housing’s decline than their competitors. And then they continued to sell mortgage securities to investors who wanted them. That was the crime that was investigated for 11 hours. Yet, each and every other bank would have done the same. If you believe that a market is changing, you have a duty to protect your shareholders. You can’t do that without lessening your exposure to a shock. How do you lessen your exposure? By purchasing protection against it or selling your long position in assets that you believe will decline.

Anyone who purchased something from Goldman that went bad didn’t do so under any false premises, despite what the Senators believe. These were sophisticated investors who were provided ample information about the securities Goldman sold. By definition, if you’re selling something, that means you don’t want it. If you did, you’d keep it for yourself. For every security that Goldman sold because the bank believed its value would decline, there was an investor who bought it because they thought it wouldn’t. Good or bad, that’s the way the market works. This is the story of every stock or bond that’s sold every day.

Does Congress really fail to understand this? Perhaps. But it’s more likely that yesterday served as a rare opportunity to gather up some nice political capital. Main Street clearly has no love for Goldman Sachs, so that makes the bank an easy scapegoat.

The hearing might help fuel some more populist anger about the importance of financial reform. Quotations will almost certainly be used on the floor of Congress to argue for the need to crack down on Wall Street. But while it might have been politically convenient to use Goldman Sachs as a punching bag for 11 hours, nothing substantial was accomplished. Going into the hearing, we thought that Goldman Sachs consisted of a bunch of really smart guys who made winning bets about the housing market and made a lot of money. Coming out of the hearing, we believe the same thing. There were no “aha!” moments, no interesting facts uncovered, no sudden realization of how the financial crisis could have been avoided.

Some form of new financial regulation will eventually pass. Goldman will have to adjust. Congress may even be naïve enough to believe that its multi-billion dollar quarters and many million-dollar bonuses will be limited. But they won’t be. If there’s one thing that’s fairly certain, it’s that smart people will always find a way to work around the system and make a lot of money. And make no mistake: there are quite a few very smart people working at Goldman Sachs.

Last week, a Senate subcommittee considered the rating agency problem. Few industries have shouldered as much blame for their part in fueling the financial crisis as the ratings industry. Their mistakes led investors to believe bonds based on mortgages would perform better than they did. For some bond types, nearly all were eventually downgraded.

There are numerous suggestions of how to deal with this problem. Kevin Drum doesn’t know of a good solution, but writes:

Turning the ratings agencies into regulated utilities might be better than the current situation, but not by much. And if you’re going to do that, why bother with ratings agencies at all? Why not just have the SEC provide ratings?

Of course, the rating agencies are practically utilities already. They are heavily protected by federal law. They essentially can’t be prosecuted for being wrong due to their ability to successfully claim First Amendment free speech regarding their ratings. The government also has set very high barriers of entry, which is why the big three remain in charge, even despite their utter failings during the housing bubble.

If there’s no clear solution to the rating agency problem, should the government just take over, as Drum quips? He ultimately thinks that probably wouldn’t work out too well, since poorly-paid bureaucrats probably will likely be even less likely to understand complex securities than the private sector analysts.

That would probably be a common first reaction. After all, the SEC’s track record isn’t great these days, having missed the Madoff and Stanford ponzi schemes, failing to act on Lehman’s problems, and facing public embarrassment after a report surfaced saying that senior staffers spent their workdays viewing pornography. Can anyone honestly, with a straight face, say that they would do any better than the rating agencies did? To see a perfect example of a government-sponsored entity doing an awful job of understanding the market, one only need to look as far as the biggest of all bailout recipients of all: failed mortgage agencies Fannie Mae and Freddie Mac.

Yet, Ezra Klein thinks putting government in charge of ratings might be a good idea. He notes:

The obvious problem is that a public rating agency might be too conservative, but on the one hand, I’m not sure that’s a bad thing, and on the other hand, the market could always ignore the rating.

Klein might have a point. If the government fails, then ratings might completely lose their meaning. Wouldn’t that force investors to just ignore ratings and do their own due diligence? This would certainly be a great outcome. In fact, it’s probably ideal. Investors should be the ones evaluating the investments they purchase — that way they retain ultimate responsibility for the performance of their portfolios.

There are a few problems still looming, however. First, Klein must have a lot of faith in investors’ willingness to work diligently. Their broad reliance on rating agencies during the housing boom, however, shows their laziness. Had they analyzed mortgage bonds themselves and took the time to better understood the market, they might have realized earlier how poor a job the rating agencies were doing in evaluating real estate-related securities.

In fact, there’s an even greater likelihood that investors would happily rely on government ratings than they did private ratings: the government could be held accountable. If the government puts a quality stamp on something, but gets it wrong, people will expect it to stand behind its word. That could result in a view that bonds have a sort of implicit guarantee to perform as the government dictates. One can only begin to imagine the investor/bank bailout that would have ensued if the government had made the same mistake as the rating agencies did during the housing bubble. It would have been far more costly than whatever the cost of the bank bailout turns out to be.

And then there are the global consequences. Imagine if the U.S. government mis-rated a universe of bonds that China was heavily invested in. Can anyone begin to doubt that the government wouldn’t feel pressured to “make good” on its ratings errors, for the sake of international diplomacy?

The best solutions to the rating agency problem would be those that would result in investors paying for ratings, whether through third-party research firms or by doing their own analysis in-house. Incentives need to be better aligned, competition needs to be introduced into the ratings market, and investors need to retain ultimate responsibility. Any “solution” that doesn’t capture those criteria will fail.

The Goldman hearing before a Senate subcommittee continued this afternoon with Senator Claire McCaskill (D-MO) addressing Goldman’s role in market making with regard to synthetic Collateralized Debt Obligations — the type of security at the heart of the SEC’s claim. McCaskill actually uses an accurate analogy for Goldman’s role, calling it a bookie. She’s right: as a market maker, Goldman and other investment banks act a lot like a bookie by lining up investors who want to take separate sides of a bet. But she takes the analogy a little too far.

Bookies set the “line” of a bet, the price and return that can result from a bet. McCaskill accuses Goldman of doing a bad job of setting the line, since those who bet on the housing market lost quite badly, while those who bet against it did quite well. The problem with this claim, however, is that unlike bookies, market makers don’t set the line — the market does. All the traders do is align investors based on market demand and supply.

So why did those who shorted the housing market in early 2007 make so much money? Because the market was very, very wrong. Thus, any securities that would have provided a short on the subprime mortgage market would have been very, very lucrative. The same thing happens when an underdog is largely expected to lose a sporting event, but wins. If the odds were 50 to 1 for that game, then anyone who took that bet would be rewarded very handsomely.

But Goldman, and other broker-dealers, didn’t set the housing market odds — investors did. Most got it very wrong, which is why so many lost so much money. Investors were so far off, they triggered the worst financial crisis since the Great Depression. The few that got it right, however, made a killing.

The early questioning in the Senate’s hearing on Goldman Sachs centered on the following question: do broker-dealers have a fiduciary duty to act in the best interest of their clients? Both Senators Carl Levin (D-MI) and Susan Collins (R-ME) wanted an answer to this question. They didn’t really get what they wanted. It’s unclear why, however, because the bankers testifying certainly could have appropriately answered the question.

That answer is related to a post from yesterday, which explained a banker’s fiduciary duty. The answer is yes and no, depending on what you mean by “best interests.” As a market maker, an investment bank does have a duty to act in the best interest of their clients, but not the way the Senators are looking for. They think Goldman should have informed its clients of its world view of how the market might perform in the future.

Market makers need to provide clients with fair market pricing along with full and accurate information about the securities that they’re selling. Goldman was not acting as an investment advisor in the examples the Senators used. As a result its bankers should not have provided clients with their opinions on the future performance of those securities.

Megan McArdle explains one reason why: because Goldman’s opinion doesn’t much matter. Large sophisticated investors have their own assumptions and beliefs about the market. They would be crazy to assume Goldman is always right about the future. Even the brilliant bankers within the walls of its 85 Broad Street headquarters get things wrong from time to time.

There’s another important reason why Goldman — or any other broker-dealer — couldn’t act in the best interest of its clients in the sense the Senators wish, however. It would literally be impossible. Much of investing is a zero-sum game. There are two sides to each bet. For a bank to favor one party over the other, then it would necessarily harm one of its clients. If it has an opinion adverse to one investor’s interests, then it would be doing that investor a disservice by providing that opinion to the other party.

That’s why all an investment bank can do is present full information to all investors and allow them to decide whether or not to buy a security. At one point Collins states that Goldman’s clients weren’t just paying big fees for efficiently conducting transactions, but for their “judgment as well.” That’s simply false. And any investor who thought Goldman put its stamp of approval on any security it sold would have been incredibly foolish.

Collins went on to suggest that Congress should impose a clear fiduciary duty on broker-dealers. Presumably, she means in the way she suggests — where a broker-dealer’s judgment on a security it sells matters. For the reasons explained, that would be completely nonsensical, because it would make a marker-maker’s job impossible. It should remain neutral on performance, and unite investors on both sides of a trade at a fair market price.

It’s unclear why Goldman’s bankers aren’t just carefully explaining this point. Their allusive techniques, which include taking as long as possible to reply to questions, providing vague answers and failing to “recollect” various things, simply makes them look worse. But it does begin to show why so many Goldman alumni find their way to Washington — they sound more like politicians than bankers.

The Conference Board says that its Consumer Confidence Index increased in April to 57.9 from 52.3 in March. That soundly beat consensus expectations of 53.5. Since February, the index has risen 11.5 points. Consumers are definitely feeling more confident about the U.S. economy.

Here’s the Conference Board’s tiny graph for Consumer Confidence:

According to the report, March’s point marks a high not seen since September 2008 — before the financial crisis hit its climax. This measure matters because it reflects Americans’ views of both business and labor market conditions. The latter still troubles many, since underemployment was around 17% in March. On average, however, even labor market sentiment must be improving according to the Conference Board’s data point for April.

This consumer confidence reading also contradicts a report from a Reuters/University of Michigan poll conducted earlier in April, which appeared to indicate that sentiment was worsening. If the Conference Board is right, then that’s good news for the recovery. In order for the economy to continue growing, Americans need to spend and invest.

The Conference Board’s sentiment measures experienced significant gains across-the-board. In addition to consumer confidence, its Present Situation Index increased to 28.6 from 25.2. Its Expectations Index also rose to 77.4 from 70.4. Again, this implies that Americans are doing better presently and foresee a brighter economic future than the recent past.

(Nav Image Credit: richkidsunite/flickr)

The young banker at the center of Securities and Exchange Commission’s case against Goldman Sachs, Fabrice Tourre will be in the hot seat today on Capitol Hill. The Senate Subcommittee on Homeland Security and Govermental Affairs has just begun its hearing titled, “Wall Street and the Financial Crisis: The Role of Investment Banks.” It should instead be subtitled, “The Role of Goldman Sachs,” as all seven witnesses are current or former Goldman employees. Tourre is on the first panel to be questioned by Senators. His prepared testimony (.pdf) makes crystal clear the defense Goldman intends to take in response to the SEC’s allegations of fraud.

If you are unfamiliar with the Goldman-SEC case, a brief synopsis can be found at the top of this post.

IKB and ACA Were Sophisticated Investors

This serves as the buyer-beware defense. Tourre says that the two investors who lost a great deal of money on the transaction — collateral manager ACA and German bank IKB — were sophisticated investors who should have understood the risks of purchasing the securities at the heart of the SEC case. This point is important because it casts doubt on two questions. First, could ACA have reasonably been misled about hedge fund manager John Paulson’s role as a short investor? Second, could IKB have been reasonably misled that the role of an independent collateral manager meant that no one else would have any influence on what might have went in the portfolio? If the answer to both of these questions is “no,” then the SEC will have a very difficult time winning its case.

ACA Was Never Mislead

One of the key disputes of fact in the case is whether Goldman Sachs, through Tourre, intentionally misled collateral manager ACA. The SEC alleges that Toure told ACA that Paulson would be a long equity investor. Tourre denies that categorically. In fact, he essentially says that ACA would have had to be crazy to think that. This will have to be hashed out in court.

Security Not Designed To Fail

Next, Tourre explains that the security in question was not designed to fail. It did poorly because the subprime mortgage market collapsed. Whether or not the security would perform depended on future events, and Goldman could not have known that the housing market would collapse. Had the housing market continued to flourish, so would have the security. Tourre adds that the bonds referenced by the security did not perform any worse than similar subprime mortgage-backed securities. The entire sector did poorly.

ACA Ultimately Selected Portfolio

Finally, Tourre says that ACA was ultimately responsible for selecting the portfolio. Possibly the strongest claim in the SEC’s case is that Goldman misled investors by representing the portfolio as having an independent collateral manager. That was ACA. But it received some suggestions from Paulson, who shorted the security it created. Whether investors should have known about that is pivotal to the SEC’s case. Tourre argues that it’s immaterial, because ACA was ultimately responsible for choosing the securities, so the disclosure was accurate. This question will also need to be decided by a court.

Things should get interesting when Tourre is grilled. His prepared testimony makes utterly clear that he denies all of the SEC’s charges, but the Senate may get more into questions of ethics. It is pretty clear that, even if Tourre didn’t break the law, there are certainly things he did to make his role in the deal look worse than it should have.

The widespread media coverage of the Securities and Exchange Commission’s case against Goldman Sachs has created some public interest about how Wall Street works. To many Main Street observers, the deal looks pretty shady. There’s some possibility that Goldman misled investors, but a new report about Deutsche Bank doing largely the same thing makes it appear that the SEC’s case could be based on a mere technicality. Goldman referred to an independent collateral agent having created the portfolio for the security purchased by investors, though a hedge fund manager was also involved. Deutsche Bank employed no such third-party, so there could have been no such deceit on its part.

Whether or not Goldman is ultimately found to have committed fraud, many people who have read some details of the case likely believe that there were ethics violations, given the appearance that Goldman believed the security would perform poorly. Shouldn’t an investment bank that creates a security have an obligation to only sell it if the bank believes it will perform well? Not necessarily.

The Role of an Investment Bank

First, it’s important to understand the role of an investment bank. It’s a glorified middle man. Its job is to bring together buyers and sellers and facilitate a transaction. This involves all sorts of financial products. Here are a few examples:

• M&A: If a firm is looking to be acquired or acquire another, an investment bank can advise it on its options, pricing, etc. It can also solicit offers and facilitate the transaction’s closing.
• Equity/Debt Sales: If a company wants to sell some stock or bonds, it can go to an investment bank. The bank can then work with the company to create an offering and find investors to purchase the resulting securities.
• Derivatives: If a company or investor wants some kind of financial exposure, an investment bank can find another company or investor who wants the opposite exposure. It can then create a derivative to satisfy the demands of both parties.

An investment bank shouldn’t be confused with a personal financial advisor. The latter is a professional who generally provides investment advice to clients, like to buy or sell a stock. An investment bank isn’t there to provide its opinion when selling securities. Its job is just to provide sufficient information to all parties so they can make their own investment decision. The exception to this rule is the equity or debt research groups that sometimes exist in investment banks specifically to provide investment advice. They are required to be isolated from the investment bank’s other activities.

An Example: Derivatives

Let’s imagine an example where an investment bank is creating a derivative based on subprime mortgage-backed securities in early 2007 — right before the market collapsed. One long investor believes the mortgage market will continue to do well, the other short investor thinks it will do poorly. What the bank believes will occur is entirely irrelevant: it’s just there to create a deal that satisfies the demands of both parties and disclose all the data they need to analyze it. If each obtains the information associated with the deal, finds it appropriate, and buys the securities offered, then the bank’s job is done.

If the bank has a fiduciary duty, which investor does it have a duty to protect? For example, imagine that the bank believed that the mortgage market was about to go bust. If it advised the long investor not to buy the security, it would be breaching its duty to the short investor. Alternatively, what if the bank believed the mortgage market would continue to thrive? Then, if it advised the short investor accordingly, it would breach its duty to the long investor. These investors’ interests necessarily conflict. The bank can’t give preference to one client over the other. For it to do its job best, it must create a security, disclose all of its characteristics, and allow investors to decide on their own whether to buy.

In fact, in this example, it would be impossible for the bank to sell both securities if it had to believe anything it sold would perform well. One security will necessarily do poorly. It’s a zero-sum trade.

Where an Investment Bank Can Go Wrong

Of course, that doesn’t mean it’s impossible for a bank to act in an ethically reprehensible way. If a bank misleads a client, then that’s fraud. But if a bank happens to believe a security might not do poorly, based on its interpretation of future events, then that’s irrelevant. Its job is just to provide sufficient information for the investors to evaluate the security within their own interpretation of future events. After all, the investment bank could very well be incorrect. Fraud would occur if the information it presents is false or inaccurate, because then investors could not have fairly assessed the security based on their own assumptions. If the data is accurate and complete, then the investors can successfully perform their analysis, and the investment bank has done its job.

Mortgage-backed securities are back! Sort of. Bloomberg reports that Citigroup is offering the first non-government backed private label MBS deal in over two years. This is a market that has been largely expected to remain frozen for some time. Is it beginning to thaw? Not exactly.

Calculated Risk has a great brief analysis of why Citi’s Sequoia Mortgage Trust 2010-H1 isn’t just any old MBS deal. It says the collateral is about as safe an MBS as an investor could possibly dream up. Here are some of the characteristics of the deal that show why this MBS will actually sell:

• The weighted FICO score is 768. This means the borrowers have pristine credit histories.
• The average loan-to-value ratio is 56%. This means, even if the mortgages have a whopping 44% loss rate, no investor will lose a penny of principal. (AAA investors have an additional 6.5% of cushion.)
• These are very rich borrowers. The average loan balance is $932,699. And despite their lofty mortgages, the average borrower’s debt-to-income ratio is only 27%.
• All but two of the 255 borrowers have income of at least $10,000 per month. 22 earn more than $100,000 per month.
• All but 16 of the borrowers have assets worth over $100,000. 76 own assets worth more than $1.05 million.
• Income and assets were verified for 100% of the borrowers.
• All but eight of the homes are primary residences.

This deal is very small at $222 million. Most MBS transactions during the boom were in the billions of dollars. It’s not likely that many squeaky-clean deals like this one can be originated at this time. So for the MBS market to really open back up, lower quality mortgages will have to be included. That, however, will likely continue to frighten investors in the near-term. So while this Citi deal is an important first step, it doesn’t indicate that there’s a lot more private-label MBS to come to market soon.

Financial reform advocates are touting a new poll they believe shows Americans overwhelming support their cause. A Washington Post-ABC News poll (.pdf) conducted over the weekend found that between 63% and 65% of respondents support stricter federal regulation on banks and Wall Street. That clashes with earlier polls that indicated much weaker support for reform. This new poll also shows something else: tepid support for some of reform’s most controversial provisions.

First, the poll determined that somewhere between 63% and 65% of respondents somewhat or strong support broader federal regulation of Wall Street and the banks. But then the pollster asked about three contentious options currently under consideration. Here are those results:

• 43% (16% strongly, 26% somewhat) support “having the federal government regulate the complex financial instruments known as derivatives.”
• 53% (27% strongly, 26% somewhat) support “requiring large banks and other financial companies to put money into a fund that would cover the cost of taking over and breaking up any large financial company that fails and threatens the broader economy.”
• 59% (36% strongly, 23% somewhat) support “increasing federal oversight of the way banks and other financial companies make consumer loans, such as mortgages and auto loans, and issue credit cards.”

All of these provisions scored lower than the 63% to 65% who said they wanted reform. They also account for the most controversial portions of the financial reform bill — those Republicans are most concerned with. This appears to indicate that Americans strongly support the idea of financial reform, but show weaker support for some of the more contentous provisions floating around Congress.

Why did financial reform score so much better in this poll than in prior ones? In early April, one poll found just 44% supported broader financial regulation. Pro-reform groups began heavy advertising campaigns around that time. But as of a week ago, the number ticked up to only 46%, according to a separate Gallup poll. What has changed in the past week? The media carried broad news coverage of the SEC’s complaint against Goldman Sachs. The timing of the case appears to have been a nice coincidence for the financial reform effort.

The U.S. Treasury could see a substantial windfall as it begins to sell its shares of Citigroup, which were obtained as a condition of its bailout. Officials announced this morning that they would begin sales of the government’s 7.7 billion shares of the banking behemoth as early as today, with a 1.5 billion initial offering. The total shares offered amount to around 27% of Citi’s shares outstanding. If sold at current share prices, then the Treasury will do quite well on its investment.

How well? It paid $3.25 per share, which accounted for $25 billion of Citi’s bailout. If it sold all its shares at the stock’s price of $4.70 as of noon, it would produce $36.2 billion — a profit of $11.2 billion, which is about a 45% return. Who knew the government was such a savvy investor?

Of course, it’s a little unclear whether the Treasury will manage to secure that price or not. The government appears to be at least as concerned with who will be purchasing these shares as for how much. The press release takes time to note that the Treasury told its broker “to provide opportunities for participation by small broker-dealers, including minority- or women-owned broker-dealers.” If this wasn’t the government we were talking about, all parties would be forced to pay the prevailing market price, but since the Treasury isn’t a profit-seeking entity, politics could be put ahead of price.

Finally, it’s also worth noting that the government chose Morgan Stanley as its broker to sell the shares. One can only imagine the populist anger that would have erupted if the Treasury had instead chosen Goldman Sachs, given the SEC inquiry announced earlier this month. Morgan Stanley is one of Goldman’s biggest competitors. According to the stock sale prospectus, the bank stands to make between $0.003 and $0.0175 per share on commission. For the 7.7 billion shares, that will amount to between $23 million and $135 million.

One of the most talked about — and controversial — new rules in the Senate Agriculture Committee’s new derivatives bill would require banks to spin off their derivatives desks. Reports indicate that the rule made it into Senate Democrats’ final version revised on Sunday. While it sounds like a fine idea for banks to simplify their businesses by not dealing derivatives, the provision would harm the market.

Perusing the Ag bill (.pdf), you won’t find any language explicitly calling for banks to spin off their derivatives business. That’s because this would be an indirect consequence caused by another provision which would forbid federal assistance for an institution that engages in the derivatives business. Without being able to utilize Federal Depository Insurance Corporation funds or emergency loans from the Federal Reserve, banks will feel they have no choice but to spin off their derivatives desks. This is a strange sort of indirect way to require banks to get out of the business of derivatives. The legislation could have instead simply forbid depository institutions from dealing derivatives. This indirect method gets there too, but only in a round-about way.

In theory, a bank could choose to continue dealing derivatives and opt out of being eligible for government assistance. But there’s little chance any depository institution could afford to shed its FDIC charter. The once traditional investment banks that obtained a bank holding company status so to gain access to the Fed’s emergency funding during the crisis — including Goldman Sachs and Morgan Stanley — might decide to rethink that move if the rule is passed. The thought of losing their lucrative derivatives businesses could cause them to choose to revert back to traditional investment banks.

It’s also useful to note that the institutions which were the biggest problems during the crisis — Lehman Brothers, Bear Sterns, Merrill Lynch, AIG and Fannie/Freddie — were not depository banks who would have qualified for such assistance. The provision would not have prevented these institutions from trading derivatives. As a result, in all likelihood, it would have had no effect in preventing the financial crisis.

Forcing banks to spin off their derivatives desks would devastate the banking industry and put U.S. firms at a significant disadvantage in the global financial market. One of the most important characteristics of a swaps dealer is its capital adequacy and creditworthiness. Counterparties and clearing houses will want to be comfortable that swap dealers won’t default. With this provision, non-U.S. banks that are still permitted to deal derivatives will have a significant advantage for this reason.

If a derivatives desk doesn’t have a bank behind it with lots of capital to better ensure its survival, the market will become less efficient. Large amounts of collateral will have to be posted for trades, and derivatives will become much more expensive. While it may be prudent to reduce the derivatives market to some extent, these new rules might go too far. Despite their recent bad press, derivatives serve an important function in both business and banking.

Even if Goldman Sachs doesn’t end up being found guilty of what the Securities and Exchange Commission alleges in its recent complaint (.pdf), one thing is for sure: the bank can’t be pleased with the negative publicity. At the center of the sleazy-looking deal is the only other defendant in the case, a young Goldman banker named Fabrice Tourre. At first, Goldman appeared to have its employee’s back, implying that no one at the firm did anything wrong. Since then, however, Tourre has been put on indefinite paid leave and de-registered in the U.K. He will soon have to testify before the U.S. Senate. Goldman can’t be too pleased with his antics.

Tourre was clearly a rising star at Goldman Sachs — a vice president by the time he was 28 and an executive director at 31. Obtaining those titles at such a young age is no small feat at any investment bank, much the less Goldman. There’s little doubt that he’s a very smart guy who made some extremely dumb mistakes. Even if he ends up being absolved of technically breaking the law, Tourre can still serve as an example to other young professionals of how not to act in business.

Take Your Job Seriously

Tourre probably thought he took his job pretty seriously. But he was clearly suffering from poor judgment or immaturity when he sent a now infamous e-mail from his work account to a friend, part of which read:

More and more leverage in the system, The whole building is about to collapse anytime now…Only potential survivor, the fabulous Fab[rice Tourre]…standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!

It’s fine to think this to oneself. It’s probably even fine to jokingly say that to a friend in a bar (just don’t get so drunk you leave your top-secret iPhone prototype there). It’s not fine to write this in an e-mail from your work address. Even if the SEC had never brought charges against Goldman, a supervisor should have been displeased with such an e-mail sent from an address ending with @gs.com.

Don’t Be Cocky

This one was probably especially hard for Tourre. After all, he was a rock star. He was pulling in more than $2 million per year before his 30th birthday. Anyone getting paid even one-tenth that amount by this age that should be proud of himself. Clearly, Tourre was living the dream.

But he shouldn’t have let that show — especially not in his work. Cockiness leads to laziness and feeling that one’s above reproach. No one is, especially not a 28-year-old. If Tourre had been a little more humble, he might have avoided some of his blunders that brought the SEC’s suit against him.

Exercise Prudence

On this one, you have to assume the facts of the SEC case are accurate, which they may not be. But if they are, then Tourre allowed hedge fund manager John Paulson to have input in creating the pool of securities that he intended to bet against. Here, Tourre should have done one of two things. Either he should have made crystal clear to the collateral manager ACA that Paulson intended to short the portfolio, or he should not have allowed Paulson to have a hand in creating the pool.

Frankly, that second option probably would have worked out okay. If Tourre had approached ACA and said he wanted them to originate a pool for a synthetic collateralized debt obligation that was backed by subprime mortgages, it would have still done so. As one report indicates, ACA was perfectly happy to pick subprime mortgages itself for the pool that turned out to be disastrous investments. So Paulson would likely have been quite pleased to bet against almost any subprime mortgage portfolio ACA came up with, even if his fund didn’t select any of the specific subprime mortgage-backed securities itself. And Paulson would have still made a lot of money.

The road to smashing success in business is not an easy one. Once you’re there, however, it is easy to make a stupid mistake that overshadows all of your hard work and ruins everything. Fabrice Tourre may one eventually overcome this setback and find success again in finance, but the tarnish will likely follow him for the rest of his career.

Almost no one disputes that the rating agencies played a major role in bringing on the financial crisis. To further investigate the mistakes they made, the Senate Committee on Homeland Security and Governmental Affairs held a hearing today where many rating agency representatives testified. There was also an enormous exhibits document (giant .pdf) referred to with facts and figures demonstrating the agencies’ epic fail, along with scores of e-mails showing their misdeeds. The lessons learned were mostly those we already knew, however: the agencies suffered from deep conflicts of interest and not enough competition.

To see just how poorly a job the agencies did in rating mortgage-related securities, you need look no further than this chart, from the exhibits provided:

You should read this chart as their percentage of failure. In the 2006 and 2007 vintages, that means their ratings ended up being generally incorrect at least 90% of the time. How could they be so wrong? Because they didn’t take into account that this could be a housing bubble (click on it for bigger image):

Amusingly, this exhibit appears to come from a Paulson & Co. presentation, the firm famous for betting against the housing market in 2007, and at the center of the Goldman-SEC case. What made the agencies ignore the historical trend line above and claim that the incredibly steep rise in prices was a new normal?

Bad Incentives

The investment banks and loan issuers were the clients of the rating agencies. If an agency decided to rate deals more conservatively, then they feared their business would flee elsewhere to find one of the other agencies that were happy to be more aggressive to get another paycheck. Numerous intra-agency e-mails in the exhibits demonstrated this point. There was incredible pressure to maintain lax standards to keep the dollars flowing.

This, however, could be easily remedied. One solution would be to revamp the system so that the agencies are no longer paid by banks and issuers. Instead, restructure things so that all agencies can rate deals and still get paid for their work. This could be done by building a fee into deals where investors pay a small fee for rated transactions. Then, divide up that fee between the agencies who choose to rate the transaction.

Not Enough Competition

The other problem stems from the fact that there’s an oligopoly of ratings firms — only three. With that little competition, it’s hard to get much diversity of opinion. If one agency decides to relax standards, the others feel pressured to follow.

The clearest solution to this would be to reduce the barriers of entry into the ratings market. Right now regulations make it very difficult to become certified as a rating agency. As long as that’s the case, the big three will continue to rule the market.

Instead the current framework should be completely dismantled. Financial firms and third-party research houses should get in the business of evaluating bonds, just like equity analysts do for stocks. In that case, there is often a diversity of views on whether to buy, hold or sell various companies’ equity. In much the same way, research arms could evaluate asset-backed securities instead of the market relying on the three agencies. This would also solve the pay problem, since these analysts would derive their income through their research services — paid by investors.

Unfortunately, the current financial reform effort in the Senate does not include any such solutions to the rating agency problem. It utterly fails to address the incentives issue and the lack of competition. Page 8 of the bill’s summary (.pdf) shows how little the legislation would do to fix these problems that clearly contributed to the financial crisis.

Purchases of new homes surged in March to an annualized rate of 411,000, an increase of 27% over February, according to the U.S. Census Bureau. That’s the fastest growth of new home sales since April 1963. While selling additional new home is an indication that consumers are feeling more bullish about the housing market, today’s news should be taken in context.

This news isn’t particularly shocking for those who follow the housing market, considering that pending home sales increased significantly in February. New home sales rising also complements yesterday’s news that the sales of existing homes increased in March. The home buyer credit, set to expire in April, was described as mostly responsible for that news. There’s little doubt that the credit also drove new home sales to increase so much last month.

It is a little shocking that home buyers aren’t more interested in looking for deals on foreclosures or short sales, however. Foreclosures hit a new high in March, so there are plenty of steals be had for bargain hunters. Yet, many Americans chose to buy new homes instead.

March’s 411,000 annualized home sales were quite good compared to the prior month’s 324,000. But after a four-month decline, February had the fewest new home sales on record — since at least January 1963. So even relatively few sales in March would have had trouble falling below February’s level. In fact, the historical numbers show how weak March’s new home sales actually were:

New home sales peaked at a rate of 1.39 million in mid-2005. Last month’s numbers would have to double to get back to the pre-housing bubble levels in the 800,000’s. You only have to look back to July 2009 to see a higher number than in March.

Last month’s increased sales also didn’t do much to help lower the inventory of new homes for sale. It dropped a measly 2,000 homes from 229,000 to 227,000. That means builders are keeping up with the demand for new houses.

While additional new construction is good news for jobs, it might not help the housing market’s price stability. As mentioned, foreclosures are still extremely high. Consequently, there is a substantial inventory of existing homes, which has increased by 9% over the past two months. The market would be better served to sell off more of the existing home inventory before ramping up the building of new houses. Then, construction jobs could still be created through renovation projects. Price stability will be hard to attain as long as overall inventory is increasing.

This recent surge in new home sales is likely fleeting. Its driving force — the home buyer credit — will be gone at the end of April. So we can expect to see strong sales of new homes again this month, but fewer come summer. If construction doesn’t slow down accordingly, then the inventory of new homes will begin growing.

Note: All statistics above are seasonally adjusted.

(Nav Image Credit: Jerome/flickr)

Americans are still feeling pretty down about their financial situation, but their sentiment is improving, according to a new Gallup poll. The survey found that 41% describe their personal financial situation as excellent or good — the lowest Gallup has measured in the past decade. But separately, the pollster also found increasing optimism.

Here’s a chart Gallup provides to show that latter trend:

As you can see, optimism and pessimism have met for the first time since late 2007 — just before the start of the recession. This is an indication that the recovery has likely begun in the minds of consumers. Yet, the previous statistic — that showing Americans’ comfort with their financial situation at a decade low — indicates a strong recovery might be unlikely. Optimism is helpful, but can be choked by troubled personal finances. If consumers don’t have money to spend, then all the positive sentiment in the world won’t do much to revitalize the economy.

Gallup also grouped the results by income level:

Those top two rows are completely unsurprising. If you make more money, you feel better about your finances.

But the bottom two rows are interesting. They show more middle- and upper-class Americans feel their situations are getting better than those who believe things are getting worse. Respondents with lower incomes, however, have a much different view. There, only a tiny 30% see reason for optimism, while nearly 50% are pessimistic. These statistics lead to the troubling conclusion that the recession has been much harder on poorer Americans, and they anticipate that their suffering will be prolonged.

Fascinatingly enough, perception must affect sentiment nearly as much as reality. Another grouping shows the poll results by political party:

While Democrats and Republicans have pretty similar feelings of how their finances are doing, they vary greatly their views of where the economy is headed. Democrats — who have their President in office and strong majorities in both houses of Congress — overwhelmingly think things are getting better versus getting worse. For Republicans, the result is flipped. But Independents appear to agree with Republicans, which probably isn’t good news for Democrats in midterm elections this November. If they believe Washington isn’t improving their financial situations, they’ll be less likely to vote for the majority’s candidates.

A separate poll from Rasmussen, also released yesterday, implies that Americans are pretty cynical when it comes to how much positive change politicians can bring to the economy anyway, however. Just 32% of respondents were at least somewhat confident that policymakers know what they’re doing when addressing the current economic problems on Wall Street. That’s down from 36% a year ago.

The above headline might seem like a joke. It isn’t. Senior staffers at the Securities and Exchange Commission were surfing Internet pornography when they should have been policing the financial system. A deeply disturbing SEC memo to Senator Chuck Grassley (R-IA) exposing this problem was reported Thursday night by ABC News. Here are some highlights via the Associated Press:

_A senior attorney at the SEC’s Washington headquarters spent up to eight hours a day looking at and downloading pornography. When he ran out of hard drive space, he burned the files to CDs or DVDs, which he kept in boxes around his office. He agreed to resign, an earlier watchdog report said.

_An accountant was blocked more than 16,000 times in a month from visiting websites classified as “Sex” or “Pornography.” Yet, he still managed to amass a collection of “very graphic” material on his hard drive by using Google images to bypass the SEC’s internal filter, according to an earlier report from the inspector general. The accountant refused to testify in his defense and received a 14-day suspension.

_Seventeen of the employees were “at a senior level,” earning salaries of up to $222,418.

_The number of cases jumped from two in 2007 to 16 in 2008. The cracks in the financial system emerged in mid-2007 and spread into full-blown panic by the fall of 2008.

On one hand, two cases in 2007 means that either it wasn’t that widespread of a problem or it hadn’t yet been detected. On the other hand, the fact that this behavior seems to have been so prevalent among senior level employees is particularly troubling. They’re the ones who should have been closely watching the financial industry and leading the way to help prevent the system from collapsing.

A few things should be concluded from this revelation. First, government computers must need better firewalls to block out this content. Second, this is a pretty grim verdict on the effectiveness of regulators. When on the verge of the most major economic crisis in around 80 years, they were watching porn instead of the financial system.

This certainly isn’t the kind of publicity the SEC needs as it begins to prosecute its high-profile case against Goldman Sachs. This memo damages the credibility of the regulator. Though, it does begin to explain why it took the SEC more than three years to bring the complaint against Goldman: its employees had other things on their minds.

Earlier today, Senate Agriculture Committee Chair Blanche Lincoln’s (D-AR) derivatives bill passed through committee. The vote was on mostly partisan lines, as Senator Chuck Grassley (R-IA) was the lone Republican vote in favor. Does this indicate that he might also be willing to cross the aisle and vote for the Banking Committee’s broader financial reform package that Democrats support? Not just yet.

In a memo addressing this question, Grassley says that he supported the derivatives bill because, while not perfect, he thinks it is on the right track. Yet, regarding the broader reform legislation, he says:

My vote for this important reform of the derivatives market doesn’t mean I’ll be able to support the larger financial reform bill on the Senate floor. The derivatives piece is significant, but that larger bill has a number of flaws that need to be resolved before I’d support it. Again, I hope the majority leadership of the Senate allows the kind of debate, negotiation and amendment process needed to make those kinds of changes so that representative government can work as it should.

Earlier today, new reports indicated that a bipartisan bill may be close. It still looks like such an effort will be necessary, because no Republican has offered to support the bill and end the threat of filibuster. The statement above makes clear that Grassley’s vote today doesn’t indicate that he intends to be that rebel swing vote.

This strategy makes sense in a political context. Grassley is from Iowa and the agricultural industry strongly supports reducing Wall Street’s influence on derivatives. Yet, Grassley clearly has no intention of going against the rest of his party and supporting the broader bill in its current form.

Paolo Pellegrini, a former top Paulson & Co employee, testified to the Securities and Exchange Commission that he told collateral agent ACA that his hedge fund would short the security at the center of the Goldman Sachs lawsuit, reports CNBC. This is hugely significant. If true, it significantly weakens the government’s case against the investment bank, because it implies that Goldman could not have misled ACA about Paulson’s involvement. Indeed, one of the hedge fund’s own managers may have told the collateral manager that a short interest was the fund’s goal.

Here’s an excerpt from CNBC’s report:

In one part of Pellegrini’s testimony, a government official asked him: “Did you tell (Schwartz) that you were interested in taking a short position in Abacus?”

“Yes, that was the purpose of the meeting,” Pellegrini responded.

“How did you explain that to her?” the government official said.

“That we wanted to buy protection on traunches of a synthetic RMBS portfolio.” Pellegrini said.

The SEC does not mention this exchange in its complaint against Goldman.

In the exchange above, Laura Schwartz was a manager at ACA. Pellegrini indicates that the entire purpose of this meeting that took place in Jackson Hole, WY was to discuss the short position that Paulson desired. Unless the SEC intends to say that Pellgrini is lying, it’s hard to imagine how this doesn’t virtually dismantle its case.

You may recall that the one clear dispute of fact from the start between Goldman and the SEC centered on what the bank told ACA about Paulson’s intent. Goldman claims that it never led ACA to believe that Paulson would be an equity investor. The SEC says it did. Pellegrini’s reported testimony provides strong support for Goldman’s side of the story.

If the SEC loses the battle in attempting to show that Goldman misled ACA, it’s left only with its claim that the bank misled investors. That, however, is more a question of law. It’s not at all clear that whoever helped choose the collateral pool is material to investors. As explained earlier, so long as an investor has accurate information with which to perform statistical evaluation of a security, it’s hard to see how the details of its portfolio’s origin matter.

The Senate Agricultural Committee passed its Chair Blanche Lincoln’s (D-AR) bill to revamp the derivatives market today. It will now take the place of the derivatives section in the Banking Committee’s broader reform legislation. Lincoln’s bill is the most aggressive attempt to date for reforming the shadowy world of Wall Street’s most complex securities. It seeks to cast light in some of those dark corners so that investors and regulators can better understand the derivatives market. The sentiment is sensible, but not all of the ideas contained in the bill are as uncontroversial as they appear. One problematic suggestion: requiring virtually all derivatives to be cleared.

Currently, several clearing houses exist for derivatives. They act as sort of middle men that net out derivative obligations and ensure that all parties eventually get what they’re owed, depending on how the derivatives perform. This might sound great, but mandatory clearing will impose a cost on the market.

The problem can be understood through an analogy. A clearing house is kind of like a bookie that takes bets, but doesn’t set odds. Let’s say Nick wants to bet that the New York Knicks will beat the Miami Heat. But another guy, Heath, thinks the Heat will win. They both contact a bookie named Clarence. If Nick knows Heath, then they could just bet each other, without Clarence’s help. But if they make the bets through Clarence, then he will ensure that each party gets its winnings. A clearing house makes a similar promise to both investors in a derivative.

Now a bookie like Clarence probably has ways of dealing with people who don’t pay up if they lose. For example, he might work with a thug who can track down a deadbeat gambler to make sure that Clarence gets what he’s owed. After all, if the loser doesn’t pay up, Clarence will have to pay the winner out of his own pocket.

Mandatory clearing would sort of force all investors to use a bookie for their derivative trades. But unlike Clarence in the example above, a clearing house doesn’t have the benefit of a thug to break both of an investor’s arms if he can’t pay.

While this example might seem silly, it brings up a serious problem. Currently, not just anyone can utilize a clearing house for derivative trades. The parties must have strong credit quality, so that the clearing house has little worry that parties will default and not be able to cover their obligations. Otherwise, the clearing house will lose money and potentially default if the losses are high enough.

If clearing is mandatory, however, not only can anyone use a clearing house for their trades, they will be required to. This puts the creditworthiness of the clearing house in peril, and could jeopardize the stability of all the trades it clears. This problem is also touched on in this post about a separate new policy that would require Fannie Mae and Freddie Mac to clear their interest rate swaps.

There are certain ways clearing houses could attempt to deal with this problem. Perhaps they will require riskier investors to post more collateral to cover potential losses; perhaps they will require risk-based fees for clearing services. Lincoln’s legislation doesn’t appear to prohibit such possibilities, so the market would likely incorporate such changes if clearing becomes mandatory.

The result would probably be a little less liquidity and a little more expense in trading derivatives. That will likely stengthen big banks/investors and hurt smaller ones. Whether that’s a good or bad thing depends on your perspective. But it does illustrate that clearing all derivative trades will come at a cost.