Author: masaccio

CEO Lloyd Blankfein signed a letter to shareholders for the Goldman Sachs annual report to shareholders, explaining the company’s position on issues that have been giving it public relations heartburn. It says Goldman Sachs acted properly in its dealings with AIG. And it says that it wasn’t betting against its clients on securities related to residential mortgages. The explanations aren’t new, but….

There were a number of reports that Goldman Sachs was betting against its clients, including this one by Gretchen Morgenson in the New York Times last December. There is a brief explanation of one way to do this, used by the hedge fund Magnetar, in this post, and a longer discussion here. Magnetar denies that it did anything wrong, and specifically denies that it would make more money if the CDOs tanked.

Blankfein tells his investors that the market for residential mortgage related products and subprime securities was volatile in the first half of 2007. Its customers all had their own views of the future, positive and negative. Clients

… came to Goldman Sachs and other financial intermediaries to establish long and short exposures to the residential housing market through RMBS, CDOs CDS and other types of instruments or transactions.
…
Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a “bet against our clients.” Rather, they served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.

The NYT article describes Goldman Sachs’ use of CDOs to bet against the housing market. Some of these CDOs were designed to hedge against losses in the company’s inventory of residential real estate backed mortgage securities. One of the CDOs, called Abacus, was a synthetic CDO. Morgenson explains:

Abacus allowed investors to bet for or against the mortgage securities that were linked to the deal. The C.D.O.’s didn’t contain actual mortgages. Instead, they consisted of credit-default swaps, a type of insurance that pays out when a borrower defaults. These swaps made it much easier to place large bets on mortgage failures.

Rather than persuading his customers to make negative bets on Abacus, Mr. Egol kept most of these wagers for his firm, said five former Goldman employees who spoke on the condition of anonymity. On occasion, he allowed some hedge funds to take some of the short trades.

There is nothing there that would be inconsistent with the Magnetar strategy. Among other things, the Magnetar strategy works best if the CDO fails, and the Abacus deals were flops.

The NYT article describes another important change in CDSs in 2005. The new rules required counterparties to post collateral if one or more triggers occurred, including a ratings downgrade or a decrease in the value of the CDO. That made it easier to collect on the CDS in the event of collapse of the CDO.

According to Bloomberg, AIG wrote protection CDSs for some of the Abacus deals. In the shareholders letter, Goldman Sachs says it demanded that AIG post more and more collateral for AIG’s prospective obligations on the CDSs. It claims it did so because the evidence it had from its market-making activities showed that the market was weakening. Of course, it knew what kind of assets were in the Abacus deals, which probably helped it have an opinion. AIG did not agree with the collateral calls, but eventually posted more collateral. Goldman Sachs claims that it bought other instruments to protect itself in case AIG didn’t pay in full. When AIG failed, Goldman Sachs got paid in full on its CDSs, effectively by taxpayers.

The Abacus transactions allow speculators place bets on the direction of the housing market. If AIG sold protection, does that mean it had a position on the housing market? Or was Goldman Sachs just taking advantage of a foolish player?

Here’s more from the letter:

Clients come to us as a market maker because of our willingness and ability to commit our capital and to assume market risk. We are responding to our clients’ desire either to establish, or to increase or decrease, their exposure to a position on their own investment views. We are not “betting against” them.

Goldman Sachs creates a new definition of “market maker”, someone who enables speculation. Blankfein thinks his company has no responsibility to share information it gathered in its position as “market maker” with the people it invites to the new casino. Evan Newmark, a columnist in the Wall Street Journal, nails the issue: are the investors customers or counterparties?

The definition of a business PR fail? The Wall Street Journal writes a humor column on your spin.

 

Have you ever wondered what a synthetic CDO is, or whether it contributed to the housing bubble? At a recent hearing held by the Financial Crisis Investigation Commission, Brooksley Born asked questions designed to get answers for you. A complete answer would lead to a fuller understanding of the role of credit default swaps in the housing bubble.

The panelists are from Citibank: Murray Barnes, was involved in risk management, and Nestor Dominguez, who worked in CDOs are the speakers. There is a brief description of CDOs at the end of this post. A synthetic CDO issues credit default swaps on other entities, including CDOs and real estate mortgage backed securities. A hybrid CDO issues credit default swaps and holds other debt instruments, such as securities of other CDOs and subprime mortgages.

Born is trying to find out if the issuance of synthetic and hybrid CDOs made the housing bubble last longer and cost more. Watching the panelists answer, you’d think they had never thought of that question. Eventually, Dominguez says it didn’t extend the housing bubble because “it didn’t require any origination.” Yves Smith explains why that is wrong in her excellent book ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. She thinks the housing bubble was significantly affected by synthetic CDOs.

A number of firms, including Goldman Sachs, are known to have bet against the securities they were selling to investors. Whoops, sorry, Goldman Sachs says it was just a market maker, and denies that they were betting against their investors.

Smith gives a detailed description of Wall Street strategies. The explanations are complex, and what follows is only a sketch. Interested readers should read Chapter 9 of ECONned closely.Smith explains that synthetic CDOs were first formed in mid-2005, when the International Swaps and Derivatives Association formalized the procedures for issuing CDSs on tranches of CDO securities. Before then, investors could buy insurance from the monoline insurance companies, like AMBAC. Suddenly anyone could write protection, or buy protection on just about any tranche of a CDO.

That led to this strategy called credit arbitrage. The hedge fund buys a low tranche of a CDO, and buys protection on the next higher tranche. For example, the hedge fund buys the BBB tranche of a mezz CDO, and buys a CDS on the A tranche. While the CDO is functioning, the BBB tranche throws off cash to the hedge fund. If the CDO fails, the hedge fund makes a big profit by collecting on the CDS if the A tranche goes down along with the BBB tranche. Mezz CDOs are full of the worst of the securities of other CDOs so that seems likely.

Magnetar took this one step further. It arranged for the organization of new CDOs. It agreed to buy the equity, the lowest tranche, of the CDO, which basically gave it a veto over the assets of the new CDO. The equity tranche gets a lot of income in the first months of the CDO. Magnetar used the money to buy CDSs on the higher tranches, betting against securities that wouldn’t have existed if it hadn’t been willing to put up the equity. Essentially, its goal was to collect on the CDS when the CDO tanked. In fact, if the CDO didn’t tank, it wouldn’t make money. Smith emphasizes that this is perfectly legal.

In order to keep this going, it was necessary for there to be more and more subprime loans. The perverse effect of credit default swaps was to encourage lending to people who absolutely would fail, so that the CDO would fail and the hedge fund organizer would profit on the CDS. Smith says it is “entirely possible that Magnetar deals account for 35% of the 2006 subprime issuance” of CDOs, which totaled $448 billion.

If Smith is right, there is no doubt that synthetic CDOs and credit default swaps extended the life of the housing bubble.

*  *  *

CDO is a general term for collateralized debt obligation. It is a debt security issued by an entity like a trust or an LLC. The entity holds a large group of debt obligations of third parties, such as credit cards, car loans, student loans or residential real estate mortgages. A pool consisting solely of residential real estate mortgages might be called a CDO, or it might be called a RMBS, for residential real estate mortgage backed security.

CDOs can have all kinds of securities in them. A single CDO might hold debt obligations issued by other CDOs, say a group of RMBSs. It might also hold subprime mortgages, or notes secured by commercial real estate, or notes issued by corporations for general purposes or any combination.

In each case, the CDO issues debt securities in tranches. Higher tranches are paid in full before lower tranches get any money. The tranches are rated differently, from AAA to BBB or lower or Not Rated. Generally people refer to the tranches by their rating. There might be 5 different tranches: AAA, AA, A, BBB, Not Rated.

The CDO might own a pool of mortgages itself. Or, it might buy a group of securities of other CDOs with different ratings. Yves Smith calls these mezzanine or “mezz” CDOs. The mezz CDOs buy a bunch of the lower rated paper from other CDOs. Even so, it issues a good sized tranche of AAA rated debt as well as the lower tranches.

 

When health insurance companies triumphantly announced they had found a loophole which would permit them to deny coverage to children with pre-existing conditions, Jon Stewart asked the right question: why were you looking for loopholes? Why are you screwing over the children? We all know the answer. These companies are in the money-making business, and health insurance is just a sideline operation. Gaming the system is a profit center.

The report (.pdf) of the court-appointed Examiner in the Lehman Brothers case gives an excellent example a finance company gaming the system. The issue is proper accounting treatment of what Lehman called Repo 105 transactions. A repo, short for repurchase agreement, is a short-term financing vehicle. Lehman sells securities to another company under a contract that requires Lehman to buy the securities back a short time later at the same price plus interest. Repos are commonly used by brokers to finance their securities inventories. The borrower gets cash, and uses it to pay for the securities it is transferring. Typically, the borrower transfers securities with a market value slightly higher than the amount of cash it gets, so that the lender is protected from short-term loss.

In repo transactions, assets decrease by the value of the securities transferred, and increase by the amount of cash received. Liabilities increase by the amount borrowed, but the borrowed money is used to pay an equal amount of debt. That returns the balance sheet close to its prior position. After the transaction, the net worth of the transferor is unchanged. Leverage is the ratio of assets to net worth. If the repo is properly recorded, leverage doesn’t change.

One of the relevant accounting rules says that a transaction in which a transferor surrenders control over assets is to be accounted for as a sale. The Examiner explains this rule as follows.

SFAS 140 also states that “The transferor has surrendered control over transferred assets if and only if all of the following [three] conditions are met”:
….
● The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or ….

Report, Vol. 3, 773. The first two conditions, which are omitted, are no-brainers. That third one looks exactly like a repo, now doesn’t it? But Lehman figured out a loophole. Lehman claimed that if the amount of collateral transferred was more than 105% of the amount received, the transaction is a sale. Lehman used that loophole to reduce the amount of leverage it reported.

As an example, suppose Lehman did a repo with Fannie Mae preferred stock. It gives stock with a value of $105 to lender and gets $100 back. It records the transfer as a sale, meaning its securities inventory goes down $105. It records an increase in an asset called “derivatives” of $5 to reflect the profit it will make when it pays off the repo at $100 and gets securities worth $105 back. Cash goes up $100. It uses the $100 to repay a short-term loan with its bank. Its liability to repurchase the securities is not recorded. After the repayment, assets are lower by $100, and liabilities are lower by $100, so net worth is unchanged.

With the same net worth but lower assets, leverage is lower than it was before the transaction. The Examiner says the effective reduction in leverage ranged from about 10% to about 13%. The Examiner asserts that this is a material difference, and gives rise to colorable claims against several Lehman employees. The Examiner also asserts that it creates a colorable claim against Lehman’s auditors, Ernst and Young. In general terms, these claims relate to the obligations of these parties to insure that the financial statements accurately reflect the financial position of the company.

The Examiner acknowledges that both the individuals and the accountants may have valid defenses. They’d better have defenses: it looks like the cops may have woken from a deep slumber, probably because the screaming from every side has been pretty loud.

Whatever those defenses are, they need to be removed. Congress has to impose liability for company management and professionals who aid and abet gaming the systems set up to protect investors and the whole economy. There isn’t any point in regulating if people can escape liability by creating fake technical compliance.

 

Alan Greenspan has produced a paper explaining the Great Crash and his proposals for new regulations to prevent another crash. To reform the system, he recommends that banks be required to maintain more capital. This minimal step won’t change the deregulation movement’s emphasis on financial market efficiency at the expense of economic stability.

Greenspan explains that there is a tradeoff between growth and stability.

I strongly doubt that stability is achievable in capitalist economies, given the always turbulent competitive markets continuously being drawn towards, but never quite achieving, equilibrium (that is the process leading to economic growth).

P. 19. This quote is from the section titled “Principles of Reform”, but it should have been in the section on risk management. In her book, ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, Yves Smith explains that the economic models in wide use today spring from the ideas of Paul Samuelson. She singles out one of Samuelson’s assumptions:

In simple terms, “ergodicity” means that no matter what happens in the world, everything will reach a point where things stop changing, which, in economics, is the prized equilibrium. It also means that a system acts consistently over time.

P. 42. Smith points out the serious consequence of this assumption: it means that stability is the natural state of the economy. It means that in designing the regulatory framework, policymakers should favor efficiency over stability. Despite the quote above, this is Greenspan’s guiding principle. He must think that the constant back and forth around the “equilibrium” is close enough for risk management and other economic models to work. P.11.

Banks and other finance companies are relying on the assumption that stability is the natural state of the economy when they argue against regulation of financial markets. They argue that such rules create inefficiencies, by which they mean they make less money. Congress bought in, and gave us financial deregulation.

Smith thinks this is foolish.

…[A]ny systems designer will tell you that stability is a first order design consideration and efficiency is second.

P. 44. Buildings should stand up, even if it means using extra materials. Concrete and rebar are expensive, but worth it. Chemical plants start with making sure that reactions take place in a safe environment. Any change must first be safe and only then is cost a consideration.

In the real world, as opposed to the imaginary economic model world, top executives are indifferent to the success or failure of the businesses they operate, because they have private wealth. The law won’t touch them, either civilly or criminally. On top of that, many businesses are now too large to fail, and the government will bail them out. Greenspan says it as if it were perfectly obvious:

I do not believe any central bank explicitly makes this calculation. But we have chosen capital standards that by any stretch of the imagination cannot protect against all potential adverse loss outcomes. There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks.

P. 17. Treasury Secretary Timothy Geithner agrees.

Greenspan acknowledges that risk management failed, because managers underestimated the size and scope of the tail risk that is a part of all risk management models. He doesn’t even address the conflict between Samuelson’s principle of ergodicity and his own view that there is not really an equilibrium point. But even if failure of risk management caused the problems of large banks, it doesn’t explain what happened to regulation.

The most important point of bank regulation is to create greater stability. Stability was not a consideration to Greenspan, or any of the other people responsible for financial deregulation. Enraptured by the pseudo-proofs of mathematicized economics, they sacrificed stability, which benefits the nation, for efficiency, which, as it turns out, only benefits the rich. Even now, Greenspan ignores stability. He thinks the only role for regulation is “inhibiting irrational behavior, when it can be identified”. P. 20.

Efficiency in financial markets is a great benefit to the rich. Even in the aftermath of the Great Crash, the richest 1% has grabbed a greater share of the nation’s wealth. They are winning this battle in the class war. The rest of us are losing. We will continue to lose as long as the likes of Geithner and Greenspan design the regulatory framework.
—————–
I discuss Greenspan’s explanation that the Great Crash was not his fault, it was the fault of the liberals, and there was nothing he could have done about it here.

 

Maddelena Penitente by Donatello is at the Museo dell’Opera del Duomo in Florence, Italy. It is a statue of St. Mary Magdalen, carved from wood and painted, though little of the paint remains. The Catholic Encyclopedia describes her as follows:

In the New Testament she is mentioned among the women who accompanied Christ and ministered to Him (Luke 8:2-3), where it is also said that seven devils had been cast out of her (Mark 16:9). She is next named as standing at the foot of the cross (Mark 15:40; Matthew 27:56; John 19:25; Luke 23:49). She saw Christ laid in the tomb, and she was the first recorded witness of the Resurrection.

Others have a stranger reading, like this person. I assume Donatello knew the traditional story of the Magdalen as a penitent person who was rescued from her sinful life by Jesus. Her life changed dramatically after meeting Jesus: she became a new person, and serving Him gave meaning to her life. Then she saw Him cruelly tortured and killed. Her life shattered. She went to the tomb early on Easter Sunday and found His body gone. The angel tells her He is risen. What does this mean? How should she live? She has known Him as a man; now she realizes He is the Son of God. And she realizes her profound separation from Him.

In the picture, the statue stands brilliantly lit in middle of the room. Try to imagine it in a dark niche in a cathedral, lit only by candles. She is late in life. She is lean, sinewy, all of the fat carved off by a life of penitence and indifference to mundane things like food. Her mouth is open in toothless prayer. Her eyes are sunk deep into her head. Her hair merges with the rags she is wearing. Both look like mud. She has no interest in the things of this world. She is waiting miserably but patiently for the next where she will be reunited with Jesus.

The punishment of the damned is separation from the Beatific Vision, separation from the Almighty. Donatello shows us the dreadful pain of that separation.

 

A recent paper shows the complete victory of the rich in the class war. If you had any doubt, consider these facts. In 1983, the 838,900 households comprising the top 1% in wealth held $6.6 trillion in financial assets (constant 2007 dollars). In 2007, the 1,161,200 households in the top 1% held $19.9 trillion. The average for each household went from $7,870,000 to $17,116,000.

To put this in perspective, in 1983, the middle quintile, the 16,779,000 households 10% on either side of the middle, held $261.7 billion, an average of $15,600 per household. That rose to $603 billion in 2007, when there were 23,224,000 households in that quintile. Each household in the middle quintile had an average of $26,000 in financial wealth. If just half of the gains to the top 20% were divided evenly among the other 80% of 2007 households, their average wealth would rise $157,776.

This and other equally astonishing facts appear in a paper written by Edward Wolff (pdf). Tables 3 and 4. Wolff’s paper is discussed in detail by William Domhoff here, with better charts. Financial assets include all assets other than home equity.

Wolff provides some estimates on the impact on wealth of the Great Crash as of July 1, 2009. His rough guess is that the impact on the very rich was substantially less than on the other groups, and that as a result, the share of wealth of the top 1% went up from 34.6% of total wealth to 37.1%. The number of households with zero or negative net worth went from 18.6% to 24.1%. That is because housing prices made up the biggest part of the wealth of the bottom four quintiles, so the losses on housing value had a huge impact. The stock market has risen further since, and housing prices have continued to decline, so it’s fair to guess that if he repeated his calculations as of today, the rich would have advanced further.

An additional source of problems for average households was the rise in their debt. For the middle three quintiles, the debt to equity ratio rose from 37% to 46% in 2007, and the debt to income ratio rose from 67% in 1983 to an astounding 157% in 2007. Wolff points to facts suggesting that the increase in debt was to finance normal consumption expenditures, and was not the result of some kind of spending binge.

One form of class war is the struggle over the allocation of the gains created by society. The rich won that struggle.

It was not an accident. It didn’t have to be that way, and it doesn’t have to be that way going forward. Nevertheless, President Obama and his economics team are trying to put the old system back in place: low taxes on the rich, speculation, unregulated shadow banking, light-touch regulation of exotic securities, malleable regulators, the whole plan of the rich.

Why would anyone except the rich support that?

 

Alan Greenspan has released a paper (.pdf) discussing the causes of the Great Crash of 2008, and the role of the Federal Reserve Board in that disaster. Unsurprisingly, he says there was nothing the Fed could have done to stop it. Equally unsurprisingly, he parrots a right-wing talking point, that the massive subprime mortgage debacle is the fault of government affordable housing programs.

He discusses the securitization of mortgages and other debt in detail. He explains that Fannie Mae and Freddie Mac “chose” to meet political pressure to increase its commitment to affordable housing by increasing their purchase of subprime mortgage securities. Fannie Mae is not a lender. It purchases mortgage loans made by private lenders, packages them into trusts, and sells securities issued by the trusts with a guarantee, based on its calculations of risk.

The New York Times explains what happened. Fannie Mae announced in 2000 that it would buy $2 trillion in loans to low-income, minority and risky borrowers by 2010. By 2004, Wall Street was cutting into the mortgage securitization business, reducing Fannie Mae’s stream of good mortgages. Investors were insisting that Fannie Mae take more risks in pursuit of profits. Lenders, like Countrywide, used their streams of mortgages as leverage to insist that Fannie Mae take on more crummy loans. Management pay and bonuses were based on volume, which encouraged risky lending at Fannie Mae just as it did at all finance companies. Congress was under Republican control throughout the period. Republicans weren’t supportive of affordable housing, and if there was Congressional pressure, it was at the behest of the banksters.

This is a relevant point, because Greenspan argues that the growth in these securities was “politically mandated, and hence driven by highly inelastic demand.” He joins with the Republicans in blaming the debacle on bad government instead of bad regulators. In fact, it is another failure of markets.

Greenspan admits that there was a housing bubble, and that participants in the market knew it. They believed they would be able to get out ahead of everyone else, so they pushed the securities rather than lose market share or vast profits. He throws up his hands, denying that there was anything he could have done.

Here is his conclusion:

Unless there is a societal choice to abandon dynamic markets and leverage for some form of central planning, I fear that preventing bubbles will in the end turn out to be infeasible. Assuaging their aftermath seems the best we can hope for. Policies, both private and public, should focus on ameliorating the extent of deprivation and hardship caused by deflationary crises. But if an effective way to defuse leveraged bubbles without a major impact on economic growth is discovered, it would be a major step forward in organizing our market economies.

For Greenspan, the only alternative to laissez-faire capitalism, is “some form of central planning”. He ignores the complex range of alternatives. The obvious solution to a “leveraged bubble” is for regulators to restrict leverage. That didn’t happen. It didn’t happen in the dot com bubble, when Greenspan refused to increase margin requirements and use other techniques to restrict lending on securities, and it didn’t happen in the housing bubble. Greenspan chose to let leverage run free, knowing full well that the government would bail out the giant banks.

There is no indication that any of the President’s economic advisers disagrees with Greenspan. As long as people who think like Greenspan are in charge, we are doomed to repeat the failures of the past.

 

There was another salvo in the shock and awe campaign to cure the deficit by cutting Social Security in the New York Times on Monday. The article claims that even before his inauguration President Obama wanted to “signal seriousness” on Social Security, by making the hard decisions on his watch. That’s easy to translate now: the President hasn’t alienated a huge section of the people who voted for him, and this is a great way to do it.

Another salvo came Thursday. The Congressional Budget Office told the NYT that revenues from FICA will not be sufficient to pay the entire cost of Social Security this year. No matter that the amount is small, and covered by interest on the securities held by the Social Security Trust Fund. Something must be done. Steny Hoyer shows the path:

… the moderate Democrat who is the House majority leader, gave a speech this month in which he called for the two parties to compromise on a mix of tax increases and benefit reductions to avert fiscal chaos. Among his options were proposals to gradually raise the retirement age for future Social Security recipients and to reduce benefits for those with high incomes.

That is just ludicrous. Why should average workers pay?

Alan Greenspan and others engineered a revision to the Social Security system in the mid-80s to meet the shortfall between revenues and payouts. The idea was that all of us would pay increased FICA and the money would be saved in a trust fund for this very day, when it is needed to fund the system. That created an immediate influx of money to the general fund of the Treasury. It was used to buy a special form of treasury bonds. The Trust Fund now holds something like $2.5 trillion of this unmarketable security.

The money was not invested into productive business or research and development or infrastructure. Those were left to languish into the current state of decrepitude. Instead, the money was used to hide the size of the deficits created by the Reagan and Bush tax cuts for the wealthy. Under the guise of protecting Social Security, Reagan and Bush and the complicit Congress raised taxes on average Americans and reduced taxes on the richest Americans.

The justification for these enormous tax cuts for the rich was the crazy “trickle-down” theory, that the rich would invest the money wisely and productively, and the entire nation would benefit from new production. The reality is that the rich didn’t invest in productive activities. They exported jobs to cheaper labor markets, and used their tax cuts and profits to speculate in financial markets. By 2008, hedge funds had some $2.5 trillion under management by one estimate [pdf]. Hedge funds make money by speculating, not investing.

Hundreds of billions more, and more hundreds of billions in bank loans, went into private equity funds. The point of these funds is to pile debt on companies, cut costs and let the company sink or swim. This money didn’t benefit anyone except the rich, and the failed loans contributed to the cost of the Great Crash.

Trickle-down is a failed conservative talking point. Now we get the equally noxious conservative solution for Social Security: cut benefits and raise FICA taxes.

There is exactly one fair solution. We raise income taxes on the richest Americans, and use the money to buy back the treasury securities that are held by the Social Security Trust Fund. There is no other fair solution. Every American, including the rich, pays into the trust fund on an equal basis. Everyone should be treated equally on account of our equal contributions.

It’s a tough decision for this President. There is no way to triangulate against us liberals, the dirty hippies. He can’t try to cut some middle and call it a compromise. He can side with the rich, and balance the Social Security problem on the backs of working Americans now and when they are too old and broken to work. Or he can side with the people who overpaid for years so the rich could have tax cuts without wrecking the budget.

It isn’t a hard decision for a Democrat.

Tags: Alan Greenspan, FICA, Social Security, taxes, trickle down, trust fund

 

The headlines say that Florida Attorney General and Republican candidate for governor Bill McCollum is leading the suit to declare health care unconstitutional, and indeed his is the first signature on the complaint (.pdf). But McCollum and his office won’t be doing much on the suit. McCollum has hired a Washington, D.C. lawyer, David Rivkin of the giant law firm Baker Hostettler, at heaven-knows-what cost to Florida taxpayers.

Rivkin has been advertising for this lawsuit. Last September, he co-authored an editorial in the Wall Street Journal arguing that the mandated purchase of insurance is a violation of the Tenth Amendment. Baker Hostettler should make enough money off the case to establish Rivkin’s rainmaker status and his bonus.

Why hire Rivkin? Why not use people in the Florida AG’s office to do this case? It would be a lot cheaper, as McCollum’s Democratic opponent, Alex Sink, says in a new campaign blast:

“Bill McCollum is using our tax dollars to pay one of his old lobbying colleagues who is now his lawyer for this frivolous lawsuit,” Sink said. “Proving once again that he will consistently play Washington politics and look out for his own interests, instead of the best interests of Floridians.”

The New York Times has experts saying this suit isn’t likely to succeed, giving added weight to Sink’s waste assertion. But before we call this another example of wingnut welfare, here’s a story.

In the late ’70s, I worked for the Tennessee Attorney General. A crusading Assistant United States Attorney, Larry Parrish, went on a porno tear. He won some cases, including a conspiracy charge against Harry Reems of Deep Throat. When that case was overturned on appeal, he worked to change Tennessee’s porno law. The state AG is required to defend the constitutionality of all laws, so the inevitable lawsuit came to us to defend. A group of us gathered in the office of the Chief Deputy, a clever and resourceful guy, and after a couple of silly jokes, we began the task of figuring out how we could defend the case without embarrassing ourselves. We eventually came up with some defenses and even a way of justifying parts of the law. The Chief Deputy took our work to the State AG.

The AG was a smart and politically astute guy. He realized that if he lost the suit, as seemed certain, the true believers behind the law would blame him for inadequately defending it. He decided to hire Parrish as a special deputy to defend the case. In those days, there were limits on what the AG could pay, which reduced the waste of taxpayer dollars. Parrish lost, Tennessee won. [Leech v. American Booksellers Association, Inc., 538 S.W. 2d 738 (Tenn. 1978).]

Eventually, Parrish went into private practice, but he continued his crusade. In the mid-’90s, he worked on a case involving topless bars. He was informally (and apparently improperly) appointed to assist the Memphis DA with the understanding that he would be paid by private sources. Parrish got over $300,000 from a “private non-profit organization that supports law enforcement efforts in opposition to obscenity….” [Cooper v. Parrish, 203 F.3d 937 (6th Cir. 2000). Para. 38 et seq.] This article says it was a whole lot more.

Now we have Rivkin, who has persuaded Florida politicians to pay him to handle a healthcare lawsuit based on his experimental Tenth Amendment claims. When Democrats do this, it’s judicial activism. How about it, McCollum: are you a judicial activist, a provider of wingnut welfare, or just a common politician willing to waste Florida’s money to pander to the crazies in your state?

Tags: Alex SInk, Bill McCollum, FL-Gov, Florida, health care bill, Larry Parrish, Rivkin, Tenth Amendment, Wingnut welfare

 

Senator Dodd’s financial reform proposal removes the supervisory authority of the Federal Reserve Board over all but the largest banks, those with total assets of $50 billion or greater. Ben Bernanke, Chair of the Fed, testified before the House Financial Services Committee on Wednesday, and made it clear that he won’t relinquish that authority without a fight. In his prepared statement (pdf), he asserts that the Fed is really good at supervision, and gains information about the state of the economy from its supervisory work. He says the Fed has a vast amount of expertise in financial matters, and needs the factual data to operate its models.

He begins with the claim that the Fed has developed expertise in “examinations of risk-management practices” for banks of all sizes. There isn’t a footnote for this remarkable claim. Last year, 140 banks failed, and so far this year, another 36 have failed. That doesn’t include the ones that would have failed if the government hadn’t rescued them, such as Bank of America and Citibank.

There isn’t much sign of actual expertise in risk management at the Fed or anywhere else. No model deals with the real world. At best, they provide some very short-term information. At worst, they lead banks and regulators to think they know what they are doing, when in fact they don’t. I have discussed this issue here, and here. Yves Smith provides further explanation in her book ECONned, discussed here. The Report of the Examiner appointed in the Lehman Brothers bankruptcy case says that the Fed was in Lehman before the collapse, along with the SEC, and had no idea of the accounting tricks the company used to conceal its near insolvency. How can you trust someone who tries to tell you a story which has been debunked by reality?

Next, the barely confirmed Fed Chair tells us that in order for the Fed to do its job of managing our economy, it needs expertise in a number of areas, all of which the Fed has. That expertise sure would have come in handy in, say 2005, as the housing sector unmoored itself from reality, and speculation and outsourcing removed capital from the productive sector. Where was the Fed as people began to bet against the housing sector in a way that increased the flow of money into increasingly toxic mortgages? All that expertise, where was it?

After some bluster about the skill deployed by the Fed after 9/11 and the 1987 stock market crash, Bernanke explains that the supervision of small banks is important to the Fed’s understanding of the economy. Last Friday, the FDIC closed seven banks with total assets of $3.32 billion, and a total expected loss to the FDIC of $1.28 billion. Good work on that supervision. The information about those collapses is on the FDIC web page, Mr. Bernanke.

All of the information the Fed gets is in the form of reports. Perhaps the Chair can hire some people to download the reports from the Federal Financial Institutions Examination Council, of which the Fed is a member. Those reports are just as good whether they come from people who work for the Fed or the FDIC. In fact, given the aggressive work of the FDIC Chair Sheila Bair, perhaps Bernanke should ask for her reports if he thinks his people need information.

Annuit Cœptis courtesy of alexander amatosi

Tags: Bair, Bernanke, FDIC, Federal Financial Instutions Examination Council, Lehman Brothers Report of Examiner, The Fed

 

Chris Hedges wrote a column for Truthdig, Calling all Rebels, which begins by discussing the miserable state of the nation. He quotes David Cay Johnson, formerly a business writer for the New York Times, saying that we are headed for a massive economic disaster. The first page is a standard rant, one that could have written by any lefty.

But then we get something different: Hedges asks why we should resist? Why don’t we just carve out a comfortable place for ourselves in the corporate state and spend our lives satisfying our personal needs? After all, he points out, the elites have done just that, as have countless functionaries, the people who tell us we must work within the system, and compromise in the spirit of compassion and generosity.

Hedges’ answer is the real surprise. He turns to the French philosopher Albert Camus, and his book The Rebel, for an answer. You don’t see a lot of references to philosophy, or to French existentialism today. It was popular when I was at Notre Dame (the 60s). I took a course in Christian Existentialism which met a requirement of all graduates. I hardly need add that it isn’t on the list of courses today. In fact, philosophy itself has lost its place in the curriculum at most colleges.

The Rebel was published in 1951. Camus and Sartre had gotten into a big fight because of Sartre’s support of the Stalinist regime in the Soviet Union. Camus, a native of Algeria, was sensitive to colonialist oppression, and knew it when he saw it. Sartre attacked the philosophy bona fides of Camus as part of that fight, and Camus responded with The Rebel.

The Rebel is a think piece. There are no data tables, no empirical studies, no effort to place the work in the pantheon of knowledge about things. It is purely a meditation on the position of the intellectually aware person in a world that ignores his existence; it asks what that person should do?

It took Camus two years to write The Rebel, mostly spent in solitude because he was recovering from tuberculosis. Two years of thinking and writing. That is what makes the book so interesting. Two years of thinking. What on earth, people today would say, requires thinking for more than a minute or two? That thinking stuff is hard, and focused thinking about a single problem for two years in the age of full-time wired-in life? Well, that is unthinkable. What does it even mean to think about the same thing for two years?

If this were a scientific exploration, an effort to understand a physical phenomenon, we would at least be able to grasp it. After all, that would mean experimenting, doing something, observing the results, thinking about them, doing another experiment, observing the results and eventually writing them up. Or if it were translating, we would understand: what did Proust mean by some specific sentence, not the word for word transliteration you get from Babelfish, but a translation that conveys the meaning he wanted to convey?

The Rebel isn’t like that, and philosophy generally isn’t like that. The Rebel isn’t a search for knowledge, but for meaning. Camus burrows deeply into his own experience of the world, and considers the experiences of others and tries to distill something worth saying about the meaning of life in the face of an uncaring universe and a society riddled with injustice.

Thinking like this is hard, and certainly we can’t expect everyone to do it, or even expect Camus to do it all the time. Here’s Hannah Arendt’s thinking:

Cliches, stock phrases, adherence to conventional, standardized codes of expression and conduct have the socially recognized function of protecting us against reality, that is, against the claim on our thinking attention that all events and facts make by virtue of their existence.

The Life of the Mind, p. 4. That perfectly describes today’s state of the art political and social discourse. Politicians and a lot of the rest of us rely on stock phrases to make decisions or at least to explain publicly the reasons for decisions. The ability to express doubt and question a stock phrase has more or less disappeared. So, when lobbyists hired by Sallie Mae tell legislators that 35,000 jobs will be lost if SAFRA passes, Senators heard the words “job loss”, and didn’t think to ask how an industry that employs about 35,000 people would vanish. That failure is repeated over and over.

Everything about modern life makes it easy to avoid reality. Thinking is our only defense, even if it is hard.

Tags: Albert Camus, Chris Hedges, Hannah Arendt, philosophy, thinking

 

[Welcome Yves Smith and Host, masaccio.] [As a courtesy to our guests, please keep comments to the book.  Please take other conversations to a previous thread.  – bev]

Yves Smith brings the same clear and concise writing to ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, her explanation of the Great Crash of 2008, that she shows every day at her website Naked Capitalism. Smith points to the abject failure of neoclassical economics as the beginning point for this disaster. The unproven assumptions of this theory were converted into Indubitable Truth by academic economists. Their careers were based on their ability to combine those Indubitable Truths with other unproven assumptions and turn them into mathematical formulas which, they said, explained the way the economy works. These ideas were widely accepted by corporate interests and their shills and think tanks, media elites and politicians, and turned into statutes and regulatory policy. Immediately the vipers on Wall Street exploited every one of the new weaknesses for personal profit, first at the expense of other traders, then at the expense of their own clients, and finally at the expense of taxpayers.

Today’s neoclassical economics started with Paul Samuelson, who realized that if he made certain assumptions, he could turn big chunks of economics into mathematical equations, and explain the US economy in a few formulas. One of his simplifying assumptions is that economy is like a pendulum. No matter where it starts, it swings towards a position of equilibrium, a place where no further motion occurs. Fortunately, and amazingly, that equilibrium is at the point of full employment.

Smith explains that this assumption has no basis in reality. Any moderately complex system has feedback loops. Some are negative, that is self-damping, like pendulums. Others are positive. They generate wilder and wilder swings until they disintegrate. It is easy to think of positive feedback loops in the economy. Smith points to the tragedy of the commons, with a real world example of the over fishing of the Great Banks. Throughout the book she describes feedback loops that contradict the equilibrium hypothesis.

She takes up several of the other mainstays of neoclassical economics, including the efficient market hypothesis and rational expectations theory, and their theoretical children, which formed the basis of financial economics. These ideas led to the complex models used by the geniuses on Wall Street. In order to make the math easier, they all assume that randomness in the economy has a Gaussian or normal distribution. The evidence shows that randomness in financial markets is much more complex, and very difficult to compute. She points to a significant economic theorem that mainstream economists had to ignore, the Lipsey-Lancaster theorem. But those annoying reality thingies didn’t stop them. Any theory is better than none, said Milton Friedman, and the equations flowed.

One of the things economists and their corporate cheerleaders have persuaded politicians and media elites to believe (or say they believe) is that all increases in gross national product are good, regardless of any costs not captured in prices, like pollution and bailouts. Therefore any practice that interferes with the workings of the markets is bound to be bad. This position is so ingrained in the political class that it is not possible to discuss any regulation, no matter how crucial, on its merits. Eventually, it led to the destruction of the regulatory framework of the New Deal and into the wasteland we now inhabit.

Smith then turns to a detailed explanation of the tricks and traps used by Wall Street traders and their supervisors. One of those tricks is that profits to be realized in the future were used to compute bonuses. Smith explains:

If you owned a commercial building, had an unbreakable lease to Uncle Sam, and also bought a contract from a AAA-rated insurer to protect you against increases in your operating costs, no one would consider it reasonable to take the future income, deduct the costs of the insurance policy, discount it back to the present day, and record all the income now. Yet banks did something very much like that on a large scale basis, and paid bonuses on those future earnings.

Of course, many of those future profits did not appear, but the traders and their supervisors had pocketed their bonuses and didn’t care.

Banks thought they could protect themselves from market risks by using models based on neoclassical economics. Smith gives us a tour of the failings of those models, and then explains why even the poorly-designed systems were not enforced. Not surprisingly, it involves bonuses to traders.

Smith shows that a credit bubble lies at the heart of the Great Crash. She shows how the shadow banking system aggravated this bubble, and describes the role of credit default swaps in the subprime mortgage/collateralized debt obligation disaster. These explanations are not quick reading, but they are crystal clear on careful reading.

Smith’s analysis of economic theory and the people who tried out their groundless theories on an unsuspecting public is devastating. Her analysis of Wall Street management and traders is equally devastating. Both groups have inflicted huge losses on all of us, but no one from either group has been held accountable.

It is customary in books like these to come up with a set of proposals to fix things. Smith doesn’t believe real reform is possible, so her

… prescriptions [for reform] assume that the supposed representatives of the public manage to free themselves of the corruption of influence by the financial lobby. Should they fail, the looting will continue, as will corrosion of the notion that the United States and other economies with powerful banking interests are indeed nations of laws.

One final thing. Smith begins her acknowledgments section by recognizing the contributions of the commenters at Naked Capitalism. All of the contributors here join that sentiment.

Tags: Econned, economists, financial crisis, Financial Fraud, Paul Samuelson, Yves Smith

 

Giant finance companies like Citibank and Sallie Mae made a lot of money securitizing student loans into asset backed securities. When that market dried up, Congress was frightened into believing that students wouldn’t be able to continue their educations and that colleges and universities would be in grave peril.

The obvious solution to that problem was to increase direct federal loans. But that wouldn’t help the big finance companies. Instead of doing something sensible, it continued its practice of bailing out corporations and passed the Ensuring Continued Access to Student Loans Act (ECASLA). That bill salvaged the old private student loan business model of companies like Sallie Mae.

One of the programs set up under ECASLA was the “Participation Program”. Sallie Mae sets up a pool of government backed student loans. The Department of Education lends the pool the face amount of the loans, charging interest at the commercial paper rate plus .5%. By September 30, 2010, Sallie Mae must either buy the student loans back from the pools at face value and repay the Department; or sell the loans to the Department at a price equal to the sum of a) face amount of the loan plus b) accrued interest plus c) a 1% origination fee which Sallie Mae paid at the outset of the transaction plus d) $75.

The Department also created a Purchase Program under which loans made after May 1, 2008 could be sold to the Department for the same price.

Sallie Mae took advantage of both programs. Here’s how they describe it in the 2010 10-K, p. F-53:

As of December 31, 2009, the Company had $9.0 billion of advances outstanding under the Participation Program. Through December 31, 2009, the Company has sold to ED approximately $18.5 billion face amount of loans as part of the Purchase Program. Outstanding debt of $18.5 billion was paid down related to the Participation Program in connection with these loan sales. These loan sales resulted in a $284 million gain. The settlement of the fourth quarter sale of loans out of the Participation Program included repaying the debt by delivering the related loans to ED in a non-cash transaction and receipt of cash from ED for $484 million, representing the reimbursement of a of one-percent payment made to ED plus a $75 fee per loan.

Even by the standards of financial reporting, that’s opaque. Let’s just say that somehow they made a huge pile of money off taxpayers.

The Participation Program works just like the HICA deal described here. Sallie Mae borrows the money on a very short term basis to make government-guaranteed loans to students. It sells the loans into an asset trust, which in turn sells a participation to the government. The participation money is used to pay for the loans from Sallie Mae. Sallie Mae uses that money to repay the very short term loan. The government charges the asset trust interest at a rate equal to the sum of the commercial paper rate plus .5%. A subsidized student loan made after July 1, 2009, bears interest at 5.6%. The commercial paper rate is about .32%, so in this example a $10,000 loan made September 1, 2009 and sold to the government on September 30, 2010, gives Sallie Mae a gross profit of $591.

Sallie Mae had $9 billion in the participation program at 12/31/09. We can get a rough guess at the amount of money Sallie Mae made by using the $10,000 example above. If all of Sallie Mae’s loans were like that, it looks like a government gift to Sallie Mae in the range of $532 million. As commenter Hoofin points out, the government could have loaned the money to students at that concessionary rate and saved ordinary people millions. It’s a perfect demonstration of the commitment of Congress to bailing out companies, not people.

Oh, and Pulaski Technical College in North Little Rock, AR? Delaware Tech? Money that could have gone to your students in Pell Grants will be used to stuff the bottom line of Sallie Mae unless you and your students call Blanche Lincoln and Mark Pryor and Tom Carper and insist that they support Students Not Banks, by voting for SAFRA. We have the tools to help you help yourself, right here.

Tags: Citibank, Department of Education, ECASLA, HICA, SAFRA, sallie mae

 

Every lender tries to borrow low and lend high. The best lenders lend into no-lose situations. By this standard, either Sallie Mae is a genius, or the federal government is a sap.

Sallie Mae specializes in student loans. Many of its loans are guaranteed by the government at 98% of face value. On top of that, at least through September 30, 2010, the government will purchase the loans for an amount equal to the sum of a) the face value of the loan, b) accrued interest, and c) $75 per loan. 2010 10-K, p. F-53.

On the borrowing side, Sallie Mae has figured out a great trick. It has an insurance subsidiary, HICA Education Loan Corporation. In January, 2010, HICA became a member of the Federal Home Loan Bank of Des Moines. The FHLB of Des Moines agreed to lend it money at unbelievably low rates. 2010 10-K, p. F-55. Sallie Mae can borrow up to $11 billion from the FHLB. The first draw was $25 million at a rate of .23%. That’s right: 23 basis points. I’m going to assume that this fabulous rate is because FHLB is lending at 1 month LIBOR, the London Interbank Offered Rate. If so, it’s a really great deal. Sallie Mae has arranged to borrow $10 billion from a group of lenders to make government guaranteed loans. The rate is commercial paper plus .5%. 2010 10-K, p. 95. Commercial paper is earning about .3%, so the FHLB gets about .57% less than private lenders.

Between the low interest rate and the government’s purchase program, Sallie Mae is guaranteed to get a gross profit to SLM equal to the difference between the face interest rate of the loan and .23% plus $75, whether or not the borrower ever makes a payment.

Here’s an example. Suppose Sallie Mae makes a subsidized loan of $10,000 to your kid for second semester at Private U. The loan bears interest at 5.6%. Sallie Mae borrows $10,000 from the FHLB, and advances the money to Private U. on January 1. It has until September 30, 2010 to sell the loan to the Department of Education. Even though you didn’t make a payment (that’s the way subsidized loans work), Sallie Mae can sell the loan to the Department of Education for $10,492.31. If the interest rates charged by the FHLB don’t change, total interest due to FHLB is $15.88. Sallie Mae repays the FHLB loan with interest, and picks up a gross profit of $476.43. The government gets the money back only when you pay the loan.

The President wants to change this and Sallie Mae and its fellow privateers are fighting to kill the House Bill with a fake compromise. Will Congress continue to let Sallie Mae play the government for saps?

Tags: Department of Education, FHLB, sallie mae, student loans, Students Not Banks

 

There are many stupid things you have to believe if you want to be taken seriously in financial matters. One of these is that free markets, those managed by brilliant Wall Street operators, allocate capital to its highest and best use. Apparently the highest and best use of $1.4 trillion dollars is hedge funds.

The whole point of hedge funds is speculation. Here’s a description from a paper by Michael King and Philipp Maier published in the Journal of Financial Stability (sorry, no link available, you can find this journal on-line at your public library):

A typical hedge fund is a private investment company that manages the funds of a limited number of wealthy individuals and institutional investors. A high minimum investment requirement, restrictions on withdrawals, and the limited audience (wealthy, “sophisticated” investors) allow hedge funds to remain unregistered and leave managers free to pursue proprietary investment strategies that would be imprudent for a more widely held mutual fund. Hedge funds use aggressive trading strategies designed to earn positive returns in all market environments, such as short sales, leverage, program trading, arbitrage, and the use of derivatives.

By wealthy and sophisticated, they mean any household with a net worth exclusive of house and personal property (cars and TVs) of $1 million. At the end of 2008, that was about 6.2 million households, about 5.5% of all households.

Hedge funds hire mathematicians and physicists, give them big computers and in return, they get formulas that use past financial market data to predict the future. Of course, real psychics are prosecuted for doing this. Why should you invest in a business, do all that hard work, and take actual risks, when you can hire geniuses to preserve capital, reduce volatility and risk, and deliver positive returns regardless of what happens to the little people in the financial markets?

And it isn’t just the $1.4 trillion, there’s leverage. About 80% of hedge funds borrow money from banks and others to increase the rate of return on their money. Hedge funds don’t report the amount of leverage, but King and Maier cite an estimate of average leverage for these companies of about 1 to 1 in December, 2006, when the money in hedge funds was a lot higher; it was an estimated $1.75 trillion at that date. The largest lenders to the hedge fund industry are huge banks, that provide brokerage services, loans, and are the counterparties to hedge funds. That means that another $1.75 trillion was pulled out of the lending pool and put into speculation, for a total of $3.5 trillion.

That is the highest and best use of money? Dumping it into the hands of a bunch of speculators to see if they can make money with derivatives and other junk investments? Let’s pretend it’s true that the best thing rich people can do with their money is to speculate with it. How does that “trickle down”? It doesn’t. That money is gone from the pool that might be invested in productive activity, a real concept no matter what professional economists and financial elites say.

King and Maier concede that failure of hedge funds can cause financial instability. But guess what? They don’t want to regulate hedge funds. They don’t explain any benefit from hedge funds, leaving us to assume that they believe that markets allocate money to its highest and best use and that any interference with that magic is evil and bad for you. They believe this so deeply it doesn’t dawn on them to discuss this critical issue.

Our authors reject the possibility of requiring transparency in the trading activities and positions of hedge funds. That would create a moral hazard, they argue, because management would assume that regulators would act if they thought there was too much risk. Even worse, it might expose the proprietary trading strategies of hedge fund managers.

Their solution is to rely on hedge fund counterparties, the too big to fail banks that provide all kinds of services to them, and compete with them by operating their own hedge funds.

The Journal of Financial Stability is my new favorite place to look for absurd rationalizations of the system that produced the Great Crash of 2008, and the Great Recession.

photo courtesy of  Phoney Nickle

Tags: economics, financial crisis, hedge funds, regulation, trickle down

 

[Ed. note: We’re republishing this piece this morning as it had the unfortunate challenge of competing with the final hockey game last night. The student loan system is an emerging topic of importance to students, faculty, staff and relevance to the financial industry and to a number of politicians — like Sen. Evan Bayh.]

Sallie Mae, the nation’s largest student loan company, is fighting to defeat President Obama’s plan to cut subsidies to private lenders of student loans. Currently, private lenders get all kinds of government subsidies, and Sallie Mae wants them all, even if it means less money for Pell Grants for our kids. To help us understand what’s at stake, I’ve been reading their SEC filings.

Sallie Mae (ticker symbol SLM) is a giant finance company. It borrows money from banks and investors, and gets more from its wholly-owned bank, and lends it to students at public and private schools at fixed interest rates. Much of its borrowing bears interest at floating rates, and some of the money it borrows is from overseas, in Euros, for example. It hedges the risk of floating rates and currency fluctuations with derivatives, primarily interest rate swaps and currency swaps.

SLM makes money in two ways: a) it profits if the total interest it pays to borrow money is less than the total interest it gets from the loans it makes to students; and b) it earns servicing fees on loans it has made and for servicing loans other companies make. In its most recent 10-K covering the year 2008, Sallie Mae says it is the nation’s largest servicer of student loans. P.6.

This .pdf document shows on lines 4-24 the income statement for the full year 2009 from SLM’s Earnings Release. SLM doesn’t report its earnings for its servicing business separately from its loan business. Making it even harder to understand, it classifies a remarkably large amount of revenue as “Other” (line 23 on the .pdf), which includes income that is attributable to the loan portfolio and to servicing income (10-K, Note 14, P. F-73). I have allocated “Other”, in part by annualizing the results on the 9/30/09 10-Q, showing my work on the .pdf.

Surprisingly, servicing income for 2009 is about $266 million greater than income from the loan portfolio. One big reason is losses from derivatives and hedging of its borrowings, $604.5 million in 2009 (line 19). That loss exceeds its net interest income after provision for loan losses of $603.8 million (line 15). Unimpressive.

It is easy to see the nature of the loan business in the financial statements. SLM borrows from a number of sources, including banks, the federal government, foreign lenders, and the shadow banking system. 10-K, P. F-44. A large part of its loans have been transferred to securitized asset trusts. SLM consolidates a number of these trusts on its own financial statements, despite the sale. The rest probably will be consolidated going forward. 10-Q, Note 1, P. 7-8.

The goal of the loan business is to lend at a higher rate than the rate it pays to borrow. That proved to be a serious problem, beginning in 2008. Its sources of borrowing were drying up, and SLM was in trouble. It was saved by the federal government, which created several programs to help student loan companies, as part of the TARP bailout and under a separate law, the Ensuring Continued Access to Student Loans Act. 10-Q P. 113 et seq.

Even so, there are problems with the business model of Sallie Mae. An S&P research report estimates that in 2010, SLM will have an interest rate spread, the difference between the rate at which it borrows and the rate at which it lends, of 1.6%, before expenses. That is higher than 2009, which will help profits. But, in order to protect itself, the company will have to continue its practice of hedging and use of swaps. The only way it can grow this part of the business is to make more loans. That will not be easy in this environment. Fitch downgraded the stock last September, citing problems with the company’s business model.

The company hasn’t paid a dividend since 2007, and hasn’t bought back its stock. In fact, it lost $2 billion trying to hedge the price of its own stock for repurchase. 10-K, P. F-64-5.

With profitability in question, and concerns about its business model, and no money for shareholders, why does SLM want to stay in this business? The answer is cash flow. At the end of 2009, the company had total loans on its books of about $144 billion. This number, and the interest income flow that it creates, justifies the outlandish salaries paid to its management. With all that money sloshing around, there is plenty for the massive lobbying effort.

No wonder SLM is resisting the effort to cut back its subsidies. How will its President, Al Lord, be able to afford clubs for his new golf course if he all he has is the profitable but boring and low-margin servicing business?

Tags: financial industry, sallie mae, sec filings, student loans

 

President Obama recently called for specific changes to regulation of the finance business. One of these proposals is an especially good idea.

The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.

There doesn’t seem to be a written proposal. The New York Times reported the following:

The administration wants to expand that cap to include all liabilities, to limit the concentration of too much risk in any single bank. Officials said the measure would prevent banks at or near the threshold from making acquisitions but would not require them to shrink their business or stop growing on their own.

The Obama administration said the new proposals were in the “spirit of Glass-Steagall” — a reference to the Depression-era law that separated commercial and investment banking, which was repealed in 1999.

The anonymous administration person betrays a fundamental ignorance of Glass-Steagall. As the NYT reporters indicate, it didn’t have anything to do with concentration. It simply barred commercial banks from engaging in investment banking. Concentration is an anti-trust issue. However, an aggressive form of the President’s proposal should help control the risk that taxpayers will have to bail out the finance business again.

Fortunately, one of the smartest Republicans, Senator Bob Corker of my home state, realizes that financial regulation is a non-partisan issue, and is working with Senator Dodd. Good financial regulation rationalizes markets, raises the opportunity cost of fraud, and gives the taxpayers some hope that they won’t be called on to bail out banks in another crisis. Senator Corker is trying to find enough common ground to move something forward. I hope he and others will recognize the value of the President’s proposal.

This stuff is complicated, and requires explanation. Here are the bullet points.

1. There is a problem of concentration in swaps dealings.
2. Trading in swaps isn’t like a real market.
3. Risk management for swaps is problematic.
4. Crucial aspects of swaps trading cannot be captured in models.
5. Counterparty risk cannot be calculated accurately.
6. There is no evidence that benefits of swaps exceed their costs.
7. How would it actually work?

I’ve written about all these things in earlier posts and will take them up again. For now, here are short takes on 2 and 7.

2. Trading in swaps isn’t like a real market.

Let’s start with credit default swaps. Theoretically, CDS players try to maintain balanced books. Suppose JPMorgan agrees to sell protection on a specified reference entity. To balance its book of CDSs, it must either sell the CDS or buy protection from another player. AIG failed to balance its book, and we know how that turned out. JPMorgan claims that it has a reasonably balanced book.

There isn’t anyone who needs to be a protection seller. Each time JPMorgan becomes a party to a new CDS, it has to engage in active selling, either to sell its CDS or to persuade someone else to sell it protection, in which case, the problem moves to that seller.

The British Financial Services Authority did a study of the retail side of Lehman Brothers swaps. It found that 46% of 157 cases involved unsuitable advice. There are plenty of similar cases of “unsuitable advice” in the US, although I am not aware of a similar study. Some people might use a tougher term than “unsuitable advice”.

The same thing is true for interest rate swaps. The big difference is that actual banks, as opposed to Goldman Sachs, have huge loan portfolios, so some interest rate swaps might balance their own loan portfolios.

This isn’t how real markets work. People aren’t talked into buying bread or TVs. When they do buy, they shop. They don’t wait for their grocer to “put them into” chicken thighs, the way brokers “put their customers” into ETFs or BBB corporate bonds. This is a business that only exists if traders can talk someone else into being a counterparty.

7. How would it actually work?

For this purpose, banks are i) bank holding companies under current law, and ii) finance businesses which would be considered too big to fail under proposed law. Initially, banks would be limited to the amount of swaps and related derivatives (those listed in the OCC reports) that they currently have. Each quarter they would be required to reduce their holdings by a specified amount. Banks insist that there is a real market. Therefore, we can expect that other buyers and sellers will take up the slack. The level of exposure would be reduced over time so that no bank would have more than 5% of the outstanding notional values of any of the various swaps.

President Obama thinks that a good idea is a good idea, regardless of who comes up with it. I hope Senator Corker and some of the other smart Republicans see the wisdom of this theory.

Tags: Corker, credit-default swaps, Dodd, financial regulation, Glass Steagall, markets, New York Times, Obama

 

There are many stupid things you have to believe if you want to be taken seriously on financial matters. These myths about economic and financial matters form the playing field for the debate over financial reform. Simon Johnson says that these myths are a kind of social capital which finance companies like JPMorgan Chase and Goldman Sachs have accumulated over the years. One channel of this influence is the revolving door, men (they’re always men) moving from the finance companies to government and back, trailing clouds of the perfume of money. Another channel is the unexamined claim of expertise of business people. These channels of influence only work because Congress and the White House uncritically accept these myths.

Here are five:

1. Finance companies are geniuses at risk management.

2. Finance companies must be allowed to grow to gargantuan size if they are to compete.

3. Finance companies allocate capital to its highest and best use, with the corollary that any government interference in finance company business is evil.

4. Open borders for trade and capital benefits all Americans. We know it benefits China. Benefits for US workers aren’t so easy to track down. Most Americans think we need to manufacture things here.

5. The US is the greatest economy in the world. Compare Germany’s manufacturing sector with ours; it offers high wages and beats the US in exports.

These and other myths are the ground on which all economic battles are fought. If we want to argue for re-imposition of Glass-Steagall, we have to start from miles away, arguing that at least some financial regulation is a good thing. If we want to argue for some kind of industrial policy, we have to overcome the rote objection that government is no good at picking winners, and that we are already the greatest. If we argue that we need to improve our infrastructure, we are told that markets will fix things, and we should privatize the infrastructure.

The myths are accepted by all of the financial elites. Peter Wallison, an employee of the American Enterprise Institute, asserts that speculation is a perfectly good thing, because it provides liquidity. That is such an obvious truth that Wallison doesn’t think people should waste time thinking about it.

Several months ago, I was on a blogger call with one of the Treasury people who was explaining the Administration’s ideas about regulating swaps. I asked if it wouldn’t be a better idea to discourage speculative activity and encourage productive investments. The official said that it was not really possible to separate the two. It doesn’t matter which party is in power, both agree on these myths.

This is a serious problem for progressives. We have not created an alternative view of capitalism, as have so many other nations. Let’s start by getting away from the myths, and thinking about society as it exists.

Right now a tiny number of people reap a massive share of the economic benefits of living in our society. IRS data shows that in 2007, the top 400 households earned an average of $345 million each, and paid income taxes at an average rate of 16.6%. Adjusted for inflation, their income increased five-fold between 1992 and 2007. Vast amounts of that wealth are going to hedge funds for the purpose of speculating. Little of it is going into productive activity. This happened while 90% of Americans didn’t even keep place with inflation over the past decade, our infrastructure deteriorated, our factories left the country, our national debt increased dramatically, and poisonous politics destroyed the ability of the majority to govern.

Here’s a first draft of a question: Why should a few people reap such a disproportionate share of the fruits of the labor of all of us? Here’s the catch: you can’t use myths or talking points. It isn’t an answer that “they earned it, they should keep it”. It isn’t an answer that the Constitution or the Founding Fathers or Adam Smith or Ayn Rand said it was a good idea. Those and other myths are out of bounds. Let’s think about whether the current structure is the best way to organize things. Here’s the rephrased question:

Assume that you know what you know today about our society. Assume you are in charge of designing the rules for our society, not knowing where you will wind up in that society. What is your justification for establishing social arrangements with the current distribution of rewards?

image courtesy cobalt123

 

The Obama administration has failed to accomplish much on the horrendous problem of foreclosures of residential houses. The one workable idea, using the Bankruptcy Code to protect homeowners, passed the House and failed in the Senate. Other plans, like HAMP, have done nothing to stem the problem. Now we have the latest proposal. Treasury will give $1.5 billion of TARP money to five of the worst-hit states, California, Florida, Nevada, Arizona and Michigan. I sat in on a call today to hear details from Diana Farrell, Deputy Director of the National Econnomic Council; Herb Allison, Assistant Secretary of the Treasury for Financial Stability; and William Apgar, Housing and Urban Development Senior Advisor for Mortgage Finance.

The Treasury has identified the problem as underwater mortgages, exacerbated by loss of earnings and underwater second mortgages. Underwater second mortgages are a serious problem, because it is almost impossible to get a workable modification to a first mortgage without getting rid of the second mortgage.

This program is designed to get these five states to create innovative programs to solve these problems. The underlying premise is that it is a good idea to encourage people who are underwater to stay in their homes. I asked why this is a good idea. Why should someone who is underwater continue to pay on a mortgage, when they will wind up paying more than the house is currently worth plus interest? Treasury seems to think this is a good idea, because when or if prices return to normal, owners can recover their down payment. That might make sense for some people, for example, people who made large down payments and are having trouble paying because of job loss. However it is irrelevant to people who took out second mortgages equivalent to their down payment, and to people whose down payment was minimal, and to people in areas where it is unlikely that prices will return to anything like bubble levels.

One plausible plan is to see whether states can figure out a way to buy out the second mortgage, so that the owner can pay the first, perhaps with some modification. That would make sense if the value of the home is within striking distance of the first mortgage. It might well help a small group of people. Baby steps are all this administration can accomplish with Congress dead set against the one thing that will work: allowing Federal Judges to modify mortgages in Chapter 13.

image courtesy Mike Licht NotionsCapital

 

There are many stupid things you have to believe if you want to be taken seriously on financial matters. One of them is called rational expectations theory. It and the efficient market hypothesis are two of the Chicago School’s economic theories that share the blame for the Great Crash of 2008. Both ideas depend on the quality of the information available to market players, and both fail when that information is rotten.

In his book, A Failure of Capitalism, and in an interview with John Cassidy in the January 11, 2010 New Yorker*, Judge Richard Posner soundly thwacks the true believers of the Chicago School. This is remarkable: Posner himself was a professor at the University of Chicago Law School, and is one of the founders of the law and economics movement, which he now espouses from the bench of the Seventh Circuit. Cassidy writes:

During our conversation, Posner questioned the entire methodology that Lucas and his colleagues pioneered. Its basic notions were the efficient-markets hypothesis, which says that the prices of stocks and other financial assets accurately reflect all the available information about economic fundamentals, and the rational-expectations theory, which posits that individuals and firms are hyper-intelligent decision-makers who have a correct model of the economy in their heads.

The rational expectations theory is described in more detail in Wikipedia:

Rational expectations is a theory in economics that the sum of all decisions of all individuals and organizations, filtered through an endogenous set of market institutions, is not systematically wrong.

The rational expectations theory and the efficient market hypothesis form the academic basis for the Iowa Electronic Market, which allows people to bet on future events, such as the outcomes of elections or the US unemployment rate. Some players know something about each of these events, but no one knows the right answer. The idea is that if there are enough players and among them they have full information, they are likely to get the right outcome.

To be useful, rational expectations and the efficient market hypothesis both require that players take into account all relevant information. I don’t doubt that there are markets where all relevant information is available to all players. And I don’t doubt that in the market for a specific stock, almost all of the relevant information is available to a lot of players.

The problem is that in many financial markets there is a lot of information that isn’t available to all players. Furthermore, there are risks outside the markets that influence outcomes about which information isn’t available or likely to be accurate. It is obvious that even good decisions based on inadequate or false information will have bad outcomes. The following discussion is based on a paper written by Tom Van Dyck of the University of Leuven.**

1. Large finance companies are interconnected in unpredictable ways. That means that unpredicted instability of one institution can cause problems for others. AIG is the obvious example. It was impossible to know which institutions would be seriously damaged if AIG couldn’t pay out on its credit default swaps.

2. Apart from problems faced by one entity, there is the risk of financial panic, which could cause runs even on solvent finance companies.

3. Lending among finance companies is dependent on trust. If they cannot be reasonably confident in the financial position of another company, they won’t lend.

4. Each finance company has its own risk management program. No company has any way to know whether the risk management program is effective, or whether it is being followed, and based on their own experience, each is likely to mis-estimate the effectiveness of the program of all others.

Each of these risks was a cause of or an aggravating factor in the Great Crash. It is inconceivable that this information was used to set the prices of those derivatives that depend on the ability of the counterparty to perform. Instead, these apparently external possibilities were assumed away by each player under the rubric of the rational expectations theory and the efficient market hypothesis.

Judge Posner is apparently angry that economists were so willing to adopt what Cassidy calls “patently unrealistic theories”. Just as the Laffer Curve is used to justify tax cuts for the rich, these ideas were used to eliminate regulation of finance companies. And the results were just as predictably awful.
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* The article is only available to subscribers, and not easily even for them, but you can very likely access the story on-line through your Public Library; the article is well worth the trouble.

** This is a working paper and the author asks that people not quote it without his consent, which I do not have. I use some of his ideas in a different sequence.