Wednesday, April 28, 2010

by Tony Blankley

Townhall.com – link to original article

The New Yort Times – link to original

OP-ED CONTRIBUTORS

By MICHAEL LEWIS and DAVID EINHORN

Published: January 3, 2009

AMERICANS enter the New Year in a strange new role: financial lunatics. We’ve been viewed by the wider world with mistrust and suspicion on other matters, but on the subject of money even our harshest critics have been inclined to believe that we knew what we were doing. They watched our investment bankers and emulated them: for a long time now half the planet’s college graduates seemed to want nothing more out of life than a job on Wall Street.

Related

Op-Ed Contributors: How to Repair a Broken Financial World (January 4, 2009)

This is one reason the collapse of our financial system has inspired not merely a national but a global crisis of confidence. Good God, the world seems to be saying, if they don’t know what they are doing with money, who does?

Incredibly, intelligent people the world over remain willing to lend us money and even listen to our advice; they appear not to have realized the full extent of our madness. We have at least a brief chance to cure ourselves. But first we need to ask: of what?

To that end consider the strange story of Harry Markopolos. Mr. Markopolos is the former investment officer with Rampart Investment Management in Boston who, for nine years, tried to explain to the Securities and Exchange Commission that Bernard L. Madoff couldn’t be anything other than a fraud. Mr. Madoff’s investment performance, given his stated strategy, was not merely improbable but mathematically impossible. And so, Mr. Markopolos reasoned, Bernard Madoff must be doing something other than what he said he was doing.

In his devastatingly persuasive 17-page letter to the S.E.C., Mr. Markopolos saw two possible scenarios. In the “Unlikely” scenario: Mr. Madoff, who acted as a broker as well as an investor, was “front-running” his brokerage customers. A customer might submit an order to Madoff Securities to buy shares in I.B.M. at a certain price, for example, and Madoff Securities instantly would buy I.B.M. shares for its own portfolio ahead of the customer order. If I.B.M.’s shares rose, Mr. Madoff kept them; if they fell he fobbed them off onto the poor customer.

In the “Highly Likely” scenario, wrote Mr. Markopolos, “Madoff Securities is the world’s largest Ponzi Scheme.” Which, as we now know, it was.

Harry Markopolos sent his report to the S.E.C. on Nov. 7, 2005 — more than three years before Mr. Madoff was finally exposed — but he had been trying to explain the fraud to them since 1999. He had no direct financial interest in exposing Mr. Madoff — he wasn’t an unhappy investor or a disgruntled employee. There was no way to short shares in Madoff Securities, and so Mr. Markopolos could not have made money directly from Mr. Madoff’s failure. To judge from his letter, Harry Markopolos anticipated mainly downsides for himself: he declined to put his name on it for fear of what might happen to him and his family if anyone found out he had written it. And yet the S.E.C.’s cursory investigation of Mr. Madoff pronounced him free of fraud.

What’s interesting about the Madoff scandal, in retrospect, is how little interest anyone inside the financial system had in exposing it. It wasn’t just Harry Markopolos who smelled a rat. As Mr. Markopolos explained in his letter, Goldman Sachs was refusing to do business with Mr. Madoff; many others doubted Mr. Madoff’s profits or assumed he was front-running his customers and steered clear of him. Between the lines, Mr. Markopolos hinted that even some of Mr. Madoff’s investors may have suspected that they were the beneficiaries of a scam. After all, it wasn’t all that hard to see that the profits were too good to be true. Some of Mr. Madoff’s investors may have reasoned that the worst that could happen to them, if the authorities put a stop to the front-running, was that a good thing would come to an end.

The Madoff scandal echoes a deeper absence inside our financial system, which has been undermined not merely by bad behavior but by the lack of checks and balances to discourage it. “Greed” doesn’t cut it as a satisfying explanation for the current financial crisis. Greed was necessary but insufficient; in any case, we are as likely to eliminate greed from our national character as we are lust and envy. The fixable problem isn’t the greed of the few but the misaligned interests of the many.

A lot has been said and written, for instance, about the corrupting effects on Wall Street of gigantic bonuses. What happened inside the major Wall Street firms, though, was more deeply unsettling than greedy people lusting for big checks: leaders of public corporations, especially financial corporations, are as good as required to lead for the short term.

Richard Fuld, the former chief executive of Lehman Brothers, E. Stanley O’Neal, the former chief executive of Merrill Lynch, and Charles O. Prince III, Citigroup’s chief executive, may have paid themselves humongous sums of money at the end of each year, as a result of the bond market bonanza. But if any one of them had set himself up as a whistleblower — had stood up and said “this business is irresponsible and we are not going to participate in it” — he would probably have been fired. Not immediately, perhaps. But a few quarters of earnings that lagged behind those of every other Wall Street firm would invite outrage from subordinates, who would flee for other, less responsible firms, and from shareholders, who would call for his resignation. Eventually he’d be replaced by someone willing to make money from the credit bubble.

OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.

The credit-rating agencies, for instance.

Everyone now knows that Moody’s and Standard & Poor’s botched their analyses of bonds backed by home mortgages. But their most costly mistake — one that deserves a lot more attention than it has received — lies in their area of putative expertise: measuring corporate risk.

Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody’s or Standard & Poor’s say, “If you put one more risky asset on your balance sheet, you will face a serious downgrade.”

The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (G.E. still does!) Large investment banks like Lehman and Merrill Lynch all had solid investment grade ratings. It’s almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody’s and Standard & Poor’s.

These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.

This is a subject that might be profitably explored in Washington. There are many questions an enterprising United States senator might want to ask the credit-rating agencies. Here is one: Why did you allow MBIA to keep its triple-A rating for so long? In 1990 MBIA was in the relatively simple business of insuring municipal bonds. It had $931 million in equity and only $200 million of debt — and a plausible triple-A rating.

By 2006 MBIA had plunged into the much riskier business of guaranteeing collateralized debt obligations, or C.D.O.’s. But by then it had $7.2 billion in equity against an astounding $26.2 billion in debt. That is, even as it insured ever-greater risks in its business, it also took greater risks on its balance sheet.

Yet the rating agencies didn’t so much as blink. On Wall Street the problem was hardly a secret: many people understood that MBIA didn’t deserve to be rated triple-A. As far back as 2002, a hedge fund called Gotham Partners published a persuasive report, widely circulated, entitled: “Is MBIA Triple A?” (The answer was obviously no.)

At the same time, almost everyone believed that the rating agencies would never downgrade MBIA, because doing so was not in their short-term financial interest. A downgrade of MBIA would force the rating agencies to go through the costly and cumbersome process of re-rating tens of thousands of credits that bore triple-A ratings simply by virtue of MBIA’s guarantee. It would stick a wrench in the machine that enriched them. (In June, finally, the rating agencies downgraded MBIA, after MBIA’s failure became such an open secret that nobody any longer cared about its formal credit rating.)

The S.E.C. now promises modest new measures to contain the damage that the rating agencies can do — measures that fail to address the central problem: that the raters are paid by the issuers.

But this should come as no surprise, for the S.E.C. itself is plagued by similarly wacky incentives. Indeed, one of the great social benefits of the Madoff scandal may be to finally reveal the S.E.C. for what it has become.

Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question, intimidate and impose rules on short-sellers — the only market players who have a financial incentive to expose fraud and abuse.)

The instinct to avoid short-term political heat is part of the problem; anything the S.E.C. does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the S.E.C.’s agenda.

IT’S not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.

The commission’s most recent director of enforcement is the general counsel at JPMorgan Chase; the enforcement chief before him became general counsel at Deutsche Bank; and one of his predecessors became a managing director for Credit Suisse before moving on to Morgan Stanley. A casual observer could be forgiven for thinking that the whole point of landing the job as the S.E.C.’s director of enforcement is to position oneself for the better paying one on Wall Street.

At the back of the version of Harry Markopolos’s brave paper currently making the rounds is a copy of an e-mail message, dated April 2, 2008, from Mr. Markopolos to Jonathan S. Sokobin. Mr. Sokobin was then the new head of the commission’s office of risk assessment, a job that had been vacant for more than a year after its previous occupant had left to — you guessed it — take a higher-paying job on Wall Street.

At any rate, Mr. Markopolos clearly hoped that a new face might mean a new ear — one that might be receptive to the truth. He phoned Mr. Sokobin and then sent him his paper. “Attached is a submission I’ve made to the S.E.C. three times in Boston,” he wrote. “Each time Boston sent this to New York. Meagan Cheung, branch chief, in New York actually investigated this but with no result that I am aware of. In my conversations with her, I did not believe that she had the derivatives or mathematical background to understand the violations.”

How does this happen? How can the person in charge of assessing Wall Street firms not have the tools to understand them? Is the S.E.C. that inept? Perhaps, but the problem inside the commission is far worse — because inept people can be replaced. The problem is systemic. The new director of risk assessment was no more likely to grasp the risk of Bernard Madoff than the old director of risk assessment because the new guy’s thoughts and beliefs were guided by the same incentives: the need to curry favor with the politically influential and the desire to keep sweet the Wall Street elite.

And here’s the most incredible thing of all: 18 months into the most spectacular man-made financial calamity in modern experience, nothing has been done to change that, or any of the other bad incentives that led us here in the first place.

SAY what you will about our government’s approach to the financial crisis, you cannot accuse it of wasting its energy being consistent or trying to win over the masses. In the past year there have been at least seven different bailouts, and six different strategies. And none of them seem to have pleased anyone except a handful of financiers.

When Bear Stearns failed, the government induced JPMorgan Chase to buy it by offering a knockdown price and guaranteeing Bear Stearns’s shakiest assets. Bear Stearns bondholders were made whole and its stockholders lost most of their money.

Then came the collapse of the government-sponsored entities, Fannie Mae and Freddie Mac, both promptly nationalized. Management was replaced, shareholders badly diluted, creditors left intact but with some uncertainty. Next came Lehman Brothers, which was, of course, allowed to go bankrupt. At first, the Treasury and the Federal Reserve claimed they had allowed Lehman to fail in order to signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when chaos ensued, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue the firm.

But then a few days later A.I.G. failed, or tried to, yet was given the gift of life with enormous government loans. Washington Mutual and Wachovia promptly followed: the first was unceremoniously seized by the Treasury, wiping out both its creditors and shareholders; the second was batted around for a bit. Initially, the Treasury tried to persuade Citigroup to buy it — again at a knockdown price and with a guarantee of the bad assets. (The Bear Stearns model.) Eventually, Wachovia went to Wells Fargo, after the Internal Revenue Service jumped in and sweetened the pot with a tax subsidy.

In the middle of all this, Treasury Secretary Henry M. Paulson Jr. persuaded Congress that he needed $700 billion to buy distressed assets from banks — telling the senators and representatives that if they didn’t give him the money the stock market would collapse. Once handed the money, he abandoned his promised strategy, and instead of buying assets at market prices, began to overpay for preferred stocks in the banks themselves. Which is to say that he essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs and a few others unnaturally selected for survival. The stock market fell anyway.

It’s hard to know what Mr. Paulson was thinking as he never really had to explain himself, at least not in public. But the general idea appears to be that if you give the banks capital they will in turn use it to make loans in order to stimulate the economy. Never mind that if you want banks to make smart, prudent loans, you probably shouldn’t give money to bankers who sunk themselves by making a lot of stupid, imprudent ones. If you want banks to re-lend the money, you need to provide them not with preferred stock, which is essentially a loan, but with tangible common equity — so that they might write off their losses, resolve their troubled assets and then begin to make new loans, something they won’t be able to do until they’re confident in their own balance sheets. But as it happened, the banks took the taxpayer money and just sat on it.

Continued at “How to Repair a Broken Financial World.”

Michael Lewis, a contributing editor at Vanity Fair and the author of “Liar’s Poker,” is writing a book about the collapse of Wall Street. David Einhorn is the president of Greenlight Capital, a hedge fund, and the author of “Fooling Some of the People All of the Time.” Investment accounts managed by Greenlight may have a position (long or short) in the securities discussed in this article

G-20 accounting rules, not bank bonuses, put the system at risk.

Wall Street Journal – September 24, 2009 – link to original

By JEFFREY FRIEDMAN

The developed world’s financial regulators and political leaders have, as one, decided what caused the financial crisis: the compensation systems used by banks to reward their employees. So the only question to be discussed at the G-20 summit that begins today in Pittsburgh is how draconian the restrictions on banker compensation should be.

The compensation theory is a familiar greed narrative: Bank employees, from CEOs to traders, knowingly risked the destruction of their companies because their pay rewarded them for short-term profits, regardless of long-term risks. It’s conceivable this theory is true. But thus far there is no evidence for it—and much evidence against it.

For one thing, according to Rene Stulz of Ohio State, bank CEOs held about 10 times as much of their banks’ stock as they were typically paid per year. Deliberately courting risk would have put their own fortunes at risk. Richard Fuld of Lehman Brothers reportedly lost almost $1 billion due to the decline in the value of his holdings, while Sanford Weill of Citigroup reportedly lost half that amount.

In the only scholarly study of the relationship between banker pay and the financial crisis, Mr. Stulz and his colleague Rüdiger Fahlenbrach show that banks whose CEOs held a lot of bank stock did worse than banks whose CEOs held less stock. (The study was published in July on SSRN.com.) Another study by compensation consultant Watson Wyatt Worldwide in July shows a negative correlation between firms’ Z scores—a measure of their risk of bankruptcy—and their use of such widely criticized practices as executive bonuses, variable pay and stock options. These studies suggest that bank executives were simply ignorant of the risks their institutions were taking—not that they were deliberately courting disaster because of their pay packages.

Ignorance of risk is also suggested in a study by Viral V. Acharya and Matthew Richardson of New York University (just published in the journal Critical Review). Their research shows that 81% of the time the mortgage-backed securities purchased by bank employees were rated AAA. AAA securities produced lower returns than the AA and lower-rated tranches that were available. Bankers greedy for high returns and oblivious to risk would have bought BBBs, not AAAs.

Even more relevant to the question of culpability in the financial system’s crisis is why banks were buying mortgage-backed securities at all.

Commercial bank capital holdings are governed by the Basel regulations, which are set by the financial regulators of the G-20 nations. In 2001, U.S. regulators enacted the Recourse Rule, amending the Basel I accords of 1988. Under this rule, American banks needed to hold far more of a capital cushion against individual mortgages and commercial loans than against mortgage-backed securities rated AA or AAA. Similar regulations, contained in the Basel II accords, began to be implemented across the other G-20 countries in 2007. The effect of these regulations was to create immense profit opportunities for a bank that shifted its portfolio from mortgages and commercial loans to mortgage-backed securities.

Bankers were of course seeking profits by purchasing mortgage-backed securities, but the evidence is that they thought they were being prudent in doing so. They bought AAA instead of more lucrative AA tranches, and they bought credit-default-swap and other insurance against default. None of this can be explained unless, on balance, the banks’ management and risk-control systems kept in check whatever incentives to ignore risk had been created by the banks’ compensation systems.

Banks did not behave uniformly. Citigroup bought as many mortgage-backed securities as it could; banks such as J.P. Morgan Chase did not. Were incentives at work? Yes. But all bankers faced the same artificially created incentive to buy mortgage-backed securities. Most bankers seem to have agreed with the regulators that the profit opportunity created by the regulations outweighed any risk in these securities, especially when they were rated AAA. But some bankers, like Morgan’s Jamie Dimon, disagreed.

That type of disagreement, otherwise known as “competition,” is the beating heart of capitalism. Different enterprises compete with each other by pursuing different strategies. These strategies encompass everything an enterprise does—including how it manages and pays its employees.

At bottom, all the practices of an enterprise are tacit predictions about which procedures will bring the most reward and which ones will avoid excessive risk. Accurate predictions bring profits and survival; mistaken predictions bring losses and bankruptcy. But nobody can know in advance which predictions are right. By allowing different capitalists’ fallible predictions to compete, capitalism spreads a society’s bets among a variety of different ideas. That, not the pursuit of self-interest, is the secret of capitalism’s achievements.

To be sure, capitalists’ different ideas are all, in the end, about how to gain profit. That’s why incentives matter. But what matters even more are diverse predictions about where profits—and losses—are likely to be found. For this reason, herd behavior is a danger to capitalism, if the herd bets wrong. But herd behavior is imposed on capitalists every time a regulation is enacted—and regulators, being as human as bankers, can be wrong.

Regulations homogenize. The Basel rules imposed on the whole banking system a single idea about what makes for prudent banking. Even when regulations take the form of inducements rather than prohibitions, they skew the risk/reward calculations of all capitalists subject to them. The whole point of regulation is to make those being regulated do what the regulators predict will be beneficial. If the regulators are mistaken, the whole system is at risk.

That was what happened with the G-20’s own Basel rules. Now the G-20 has decided to blame the crisis on bank compensation systems, which it proposes to homogenize just as it had previously homogenized bank capital allocation. What has not been explained is why we should trust that the G-20’s regulations won’t be mistaken once again.

Mr. Friedman is a visiting scholar in the government department at the University of Texas, Austin, and the editor of the journal Critical Review, which has just published a special issue on the causes of the financial crisis.

Tariffs, rising state and federal taxes, and currency devaluation ruined the 1930s, and they could do the same today.

By ARTHUR B. LAFFER

Wall Street Journal – SEPTEMBER 22, 2009 – link to original

The 1930s has become the sole object lesson for today’s monetary policy. Over the past 12 months, the Federal Reserve has increased the monetary base (bank reserves plus currency in circulation) by well over 100%. While currency in circulation has grown slightly, there’s been an impressive 17-fold increase in bank reserves. The federal-funds target rate now stands at an all-time low range of zero to 25 basis points, with the 91-day Treasury bill yield equally low. All this has been done to avoid a liquidity crisis and a repeat of the mistakes that led to the Great Depression.

Even with this huge increase in the monetary base, Fed Chairman Ben Bernanke has reiterated his goal not to repeat the mistakes made back in the 1930s by tightening credit too soon, which he says would send the economy back into recession. The strong correlation between soaring unemployment and falling consumer prices in the early 1930s leads Mr. Bernanke to conclude that tight money caused both. To prevent a double dip, super easy monetary policy is the key.

While Fed policy was undoubtedly important, it was not the primary cause of the Great Depression or the economy’s relapse in 1937. The Smoot-Hawley tariff of June 1930 was the catalyst that got the whole process going. It was the largest single increase in taxes on trade during peacetime and precipitated massive retaliation by foreign governments on U.S. products. Huge federal and state tax increases in 1932 followed the initial decline in the economy thus doubling down on the impact of Smoot-Hawley. There were additional large tax increases in 1936 and 1937 that were the proximate cause of the economy’s relapse in 1937.

In 1930-31, during the Hoover administration and in the midst of an economic collapse, there was a very slight increase in tax rates on personal income at both the lowest and highest brackets. The corporate tax rate was also slightly increased to 12% from 11%. But beginning in 1932 the lowest personal income tax rate was raised to 4% from less than one-half of 1% while the highest rate was raised to 63% from 25%. (That’s not a misprint!) The corporate rate was raised to 13.75% from 12%. All sorts of Federal excise taxes too numerous to list were raised as well. The highest inheritance tax rate was also raised in 1932 to 45% from 20% and the gift tax was reinstituted with the highest rate set at 33.5%.

But the tax hikes didn’t stop there. In 1934, during the Roosevelt administration, the highest estate tax rate was raised to 60% from 45% and raised again to 70% in 1935. The highest gift tax rate was raised to 45% in 1934 from 33.5% in 1933 and raised again to 52.5% in 1935. The highest corporate tax rate was raised to 15% in 1936 with a surtax on undistributed profits up to 27%. In 1936 the highest personal income tax rate was raised yet again to 79% from 63%—a stifling 216% increase in four years. Finally, in 1937 a 1% employer and a 1% employee tax was placed on all wages up to $3,000.

Because of the number of states and their diversity I’m going to aggregate all state and local taxes and express them as a percentage of GDP. This measure of state tax policy truly understates the state and local tax contribution to the tragedy we call the Great Depression, but I’m sure the reader will get the picture. In 1929, state and local taxes were 7.2% of GDP and then rose to 8.5%, 9.7% and 12.3% for the years 1930, ‘31 and ‘32 respectively.

The damage caused by high taxation during the Great Depression is the real lesson we should learn. A government simply cannot tax a country into prosperity. If there were one warning I’d give to all who will listen, it is that U.S. federal and state tax policies are on an economic crash trajectory today just as they were in the 1930s. Net legislated state-tax increases as a percentage of previous year tax receipts are at 3.1%, their highest level since 1991; the Bush tax cuts are set to expire in 2011; and additional taxes to pay for health-care and the proposed cap-and-trade scheme are on the horizon.

In addition to all of these tax issues, the U.S. in the early 1930s was on a gold standard where paper currency was legally convertible into gold. Both circulated in the economy as money. At the outset of the Great Depression people distrusted banks but trusted paper currency and gold. They withdrew deposits from banks, which because of a fractional reserve system caused a drop in the money supply in spite of a rising monetary base. The Fed really had little power to control either bank reserves or interest rates.

The increase in the demand for paper currency and gold not only had a quantity effect on the money supply but it also put upward pressure on the price of gold, which meant that dollar prices of all goods and services had to fall for the relative price of gold to rise. The deflation of the early 1930s was not caused by tight money. It was the result of panic purchases of fixed-dollar priced gold. From the end of 1929 until early 1933 the Consumer Price Index fell by 27%.

By mid-1932 there were public fears of a change in the gold-dollar relationship. In their classic text, “A Monetary History of the United States,” economists Milton Friedman and Anna Schwartz wrote, “Fears of devaluation were widespread and the public’s preference for gold was unmistakable.” Panic ensued and there was a rush to buy gold.

In early 1933, the federal government (not the Federal Reserve) declared a bank holiday prohibiting banks from paying out gold or dealing in foreign exchange. An executive order made it illegal for anyone to “hoard” gold and forced everyone to turn in their gold and gold certificates to the government at an exchange value of $20.67 per ounce of gold in return for paper currency and bank deposits. All gold clauses in contracts private and public were declared null and void and by the end of January 1934 the price of gold, most of which had been confiscated by the government, was raised to $35 per ounce. In other words, in less than one year the government confiscated as much gold as it could at $20.67 an ounce and then devalued the dollar in terms of gold by almost 60%. That’s one helluva tax.

The 1933-34 devaluation of the dollar caused the money supply to grow by over 60% from April 1933 to March 1937, and over that same period the monetary base grew by over 35% and adjusted reserves grew by about 100%. Monetary policy was about as easy as it could get. The consumer price index from early 1933 through mid-1937 rose by about 15% in spite of double-digit unemployment. And that’s the story.

The lessons here are pretty straightforward. Inflation can and did occur during a depression, and that inflation was strictly a monetary phenomenon.

My hope is that the people who are running our economy do look to the Great Depression as an object lesson. My fear is that they will misinterpret the evidence and attribute high unemployment and the initial decline in prices to tight money, while increasing taxes to combat budget deficits.

Mr. Laffer is the chairman of Laffer Associates and co-author of “The End of Prosperity: How Higher Taxes Will Doom the Economy—If We Let It Happen” (Threshold, 2008).

After the Fall
by Jeffrey Friedman

The Weekly Standard
09/21/2009, Volume 015, Issue 01 – link to original

A Failure of Capitalism
The Crisis of ‘08 and the Descent into Depression?by Richard A. Posner?Harvard, 368 pp., $23.95

As we would expect from Richard Posner, the distinguished and polymathic writer, law professor, and circuit court judge, his book on the financial crisis is thoughtful, rigorous, and balanced.

It has also been hailed as “an event” by some on the left, such as Nobel laureate economist Robert Solow, in whose eyes it marks the conversion of Posner, a former free-marketeer (albeit no ideologue), to the tenets of progressive common sense. For this volume claims that, since 2008, we have been experiencing “a failure of capitalism,” and Posner’s takeaway point is that “we need a more active and intelligent government to keep our model of capitalism from running off the rails.”

Strictly speaking, Posner is right: We would need an active and intelligent government to keep the model of capitalism used by Posner from running off the rails. But in truth, Posner’s model tells us little about the real world factors that produced the financial crisis. And once we take account of facts that Posner overlooks, it seems that the cause of the crisis was not the “laissez-faire economic regime” that Posner imagines might have been responsible, but the legal regulations that actually shaped the behavior of our banks.

Many different economic models can explain what might have caused the crisis. But readers will want to know what actually did cause the crisis. Posner tells us much about the economics of depressions in the abstract, the economics of housing in the abstract, the economics of banking in the abstract, and the economics of corporate compensation in the abstract. All of this economic theory is valuable; but in principle, most of it could have been written in 1999, 1989, or 1939–any time after Keynes’s General Theory appeared in 1936. (Posner is a recent convert to Keynes’s macroeconomics.) What A Failure of Capitalism lacks is evidence showing that any of these theories explains the crisis of 2008.

The heart of Posner’s case against “capitalism” is the following theory, which has been embraced by no less than the president of the United States: Perverse incentives, created by banks’ executive-compensation systems, caused the crisis. As Posner puts it, bank executives’ pay was structured so that bankers would think to themselves,

when the bubble bursts you’ll be okay because you have negotiated a generous severance package with your board of directors. .??.??. The board will have hired a compensation consultant who will have advised generosity in fixing the compensation of senior management and as part of that largesse will have recommended that senior executives receive a fat severance package (a “golden parachute”) if they are terminated.

Moreover, according to Posner, subordinate employees had essentially the same incentives as top executives. Subordinates received bonuses for making money but were not penalized for losing it.

The theory is perfectly logical, and it might explain the crisis, but Posner does not show that it actually does explain the crisis.

For one thing, he doesn’t show that all banks used the same compensation system and paid the same bonuses for risk-taking. There are, in fact, differences among banks’ compensation systems, so Posner might have been able to test his theory by seeing if the banks that took more risks were the ones that provided bigger golden parachutes or paid higher bonuses. But Posner treats “banks” as a homogeneous lump. This makes it difficult for him to check his theory against reality.

Moreover, despite having written the bible of the “law and economics” movement–his 1973 treatise Economic Analysis of the Law–Posner tells us too little about the many laws that regulate real world capitalism, which surely must have affected bankers’ behavior. For instance, some of the investment banks that avoided mortgage-backed securities, such as Brown Brothers Harriman, are structured as partnerships; this encourages prudence because each partner has a lot at stake if the firm goes under. As the huge law firms demonstrate, partnerships need not be small–there can be hundreds or thousands of partners. But Richard Rahn has pointed out that the tax code–not capitalism–discourages partnerships in banking and other industries.

A Failure of Capitalism contains a devastating rebuttal of widely popular “irrational exuberance” explanations of the crisis. This leaves Posner to solve the puzzle of why rationally self-interested bankers seemed to ignore risk. But in the real world of contemporary capitalism, rational self-interest does not conform to the patterns it would follow under “a laissez-faire economic regime.” Instead, rational self-interest follows the tens of thousands of pages of the tax code; it follows the millions of pages of the regulatory code. And these tortuous legal pathways are largely overlooked by Posner.

Thus, he argues that the most important risky behavior prompted by the banks’ compensation structures was that bankers increased their leverage ratios. But banks’ leverage ratios are regulated by law, and this law, unmentioned by Posner, was probably the main cause of the crisis.

A bank’s leverage ratio consists of its capital divided by its assets, and its assets include its loans, such as mortgages. We usually think of loans as debits because most of us are borrowers. But to a lender, a mortgage (for instance) is an asset because it is supposed to be paid back. All assets are risky in an uncertain world, but a loan is especially risky, since any number of factors might cause a borrower not to pay it back. By increasing the ratio of mortgages and other loans to its capital, a bank is taking on more risk, even if the mortgages themselves aren’t riskier–and subprime mortgages were riskier.

“Banks wanted to make risky mortgage loans,” Posner writes, but this seemingly irrational behavior was mainly due, he explains, to the bankers’ rational-self interest: They were being paid to ignore risk. But since Posner homogenizes “banks” into an undifferentiated mass, he cannot tell us which bankers are supposed to have known they were taking excessive risks. And they would have had to know that if they were, as the executive-compensation theory maintains, deliberately ignoring risk in pursuit of a bigger bonus.

Nor can Posner tell us whether all banks “leveraged up” to the same degree (they didn’t) or made subprime loans to the same degree (they didn’t). If all bankers had essentially the same incentives because of the way they were paid, what could explain their actually heterogeneous behavior?

Meanwhile, Posner does not discuss the legal rules that govern banks’ leverage ratios in the real, far-from-laissez faire world. These regulations go under the name of the “Basel accords” after the Swiss town where, in 1988, the developed world’s central bankers agreed to them. The Basel accords set a ceiling on banks’ leverage by regulating the amount of capital banks must hold–and, crucially, the type of assets they may hold.

The Basel accords required a minimum level of 8 percent capital for lending banks (as opposed to investment banks) yielding a 12.5-to-1 ratio of assets to capital–once assets were adjusted for the riskiness that the Basel regulators saw in different types of assets. For instance, they saw zero risk in cash but 50 percent risk in mortgages, so a bank needed to hold no capital against cash but 4 percent capital against mortgages. To the Basel accords, each country’s regulators were free to add their own fillips.

Ten years after the Basel accords were implemented in the United States, the American regulators amended them. Under the “Recourse Rule,” adopted in 2001, mortgage-backed securities were risk-weighted at 20 percent, requiring 60 percent less capital than actual mortgages required. The only qualification was that the mortgage-backed securities had to be rated AA or AAA by one of the three “rating agencies,” Moody’s, Standard and Poor’s, or Fitch.

These three private companies had a legally protected oligopoly. The oligopoly found a way to give AA and AAA ratings to slices of mortgage-backed securities that consisted entirely of subprime mortgages. Thus, the Recourse Rule created an incentive for lending banks to “leverage up” by originating as many mortgages as possible, selling them for securitization to an investment bank such as Bear Stearns, and buying them back as part of an AA- or AAA-rated security. Thus could a bank increase its lending power–hence its potential profitability–by 60 percent per transaction.

Would this have been “normal business activity in a laissez-faire economic regime,” as Posner contends? No. But it was consistent with the rational self-interest of bankers under the amended Basel accords. The Recourse Rule did not force anyone to leverage up; but it richly rewarded those bankers who–like the regulators themselves–saw little risk in leveraging up by buying highly rated mortgage-backed securities.

The Recourse Rule, however, gave banks the same ability to increase their leverage whether they bought AA-rated or AAA-rated securities. If the reason that “banks” were leveraging up in the first place is, as Posner maintains, that they cared only about profits and ignored possible losses (because their executives and employees were compensated for short-term profits, regardless of the long-term risks), then banks should have bought AA securities every time: The AAs paid more than the AAAs–precisely because they were riskier.

But in fact, only 19 percent of the mortgage-backed securities held by the banks were rated AA or lower. Eighty-one percent were rated AAA, yielding less short-term profit because they carried less risk. This one fact may refute the executive-compensation theory all by itself.

Another inconvenient fact: If banks were seeking to maximize their leverage because they were heedless of the risk, then they should have driven their capital holdings down to the minimum allowed by law: 8 percent for “adequately capitalized” banks; 10 percent for “well-capitalized” banks, to which American regulators give privileges that most banks need. But in December 2007, as the crisis was getting underway, the average capital level of all American banks combined was roughly 13 percent–30 percent higher than the legal minimum.

This level had indeed declined from previous levels, so it is true that, in the aggregate, “banks” had leveraged up, just as the Recourse Rule would have led us to expect. The banks’ greater leveraging, however, cannot have been caused by the general indifference to risk blamed by Posner since, if there were any such indifference, the banks’ average capital ratio would have been 30 percent lower than it actually was.

These facts dovetail with a recent study by René Stulz and Rüdiger Fahlenbrach showing that banks with CEOs who held a lot of stock in the bank did worse than banks with CEOs who held less stock. Whatever mistakes they made, the CEOs were not making them deliberately, contrary to the executive-compensation theory.

What seems to have happened, then, is not that banks ignored risk. Rather, to the extent that generalizations can be made, banks tried to avoid “excessive” risk–but different bankers had different ideas about what was excessively risky and what wasn’t. Some bankers, such as those at Citigroup, saw little risk in leveraging up: Its capital level at the end of 2007 was 10.7 percent, barely above the legal minimum. Others, such as those at JPMorgan Chase, saw greater risk: Its capital level was 12.57 percent, and it avoided subprime securities despite the incentives offered by the Recourse Rule, because even those incentives were not large enough to compensate for the risk perceived by the Morgan bankers.

“Banks” did not homogeneously leverage up by buying mortgage-backed securities, heedless of the risk; their willingness to seize the rewards offered by the Recourse Rule varied according to their differing perceptions of the risk involved.

This thesis is borne out by two sensationalized but fact-stuffed books about Bear Stearns and JPMorgan: William D. Cohan’s House of Cards and Gillian Tett’s Fool’s Gold. From Cohan we learn that neither the Bear Stearns executives nor the subordinates whose actions brought down the bank had any idea that they were taking “excessive” risks. From Tett (whose book appeared too late for Posner to consider) we learn that the conservative risk perceptions of JPMorgan president Jamie Dimon and his subordinates counteracted the very real temptation to leverage up.

Was Dimon less rationally self-interested than Bear Stearns president Jimmy Cayne? No, but Cayne and his subordinates didn’t see the same risks that Dimon and his subordinates saw, or thought they saw, in AAA-rated mortgage-backed securities.

Under any version of capitalism, laissez faire or regulated, the rational pursuit of self-interest characterizes the successful companies, like JPMorgan. But it also characterizes the failures, like Bear Stearns and Citigroup. Therefore, a realistic “model” of capitalism has to contain more than rational self-interest if it is going to explain capitalists’ mistakes–and in the financial crisis of 2008, there were plenty of those.

If we are going to understand these errors, we have to bear in mind that capitalists have different ideas about how to pursue their self-interest–including different ideas about how to avoid undue risk. Unless capitalists’ ideas about these matters were different, there’d be no economic case for competitive capitalism. Competition is the only way to sort out the good ideas from the bad ones. The good ideas help a company survive and prosper; the bad ones cause losses or bankruptcy.

If anybody really knew in advance which ideas were good and which were bad, there’d be no point testing the ideas against each other through competition. But the hidden premise of banking regulations such as the Basel rules is that regulators can, indeed, know such things in advance. This premise puts the regulators in the position of trying to be omniscient judges of what constitutes “prudent” behavior. In 2001, the American regulators had decided that it would be more prudent for banks to hold AA or AAA rated mortgage-backed securities than to hold actual mortgages, so banks that made this switch were rewarded with 60 percent more potential profits.

Among fallible human beings, of course, what constitutes prudence is a matter of legitimate dispute. But unlike capitalists’ ideas about prudence, regulators’ ideas cannot compete against each other to sort out the bad from the good: Only one regulation at a time is the law of the land. So if we see a high proportion of capitalist enterprises making the same mistakes, as we do when we look back at the run-up to the crisis, we might suspect that a homogenizing force–such as the incentives imposed on all banks by mistaken regulations–were at work.

If one seeks the cause of a systemic problem, a logical place to look is among the laws that govern the system as a whole. Individual capitalists, of course, make mistakes all the time; we discover this when they go broke. And being human, they are as susceptible as anyone to herding around the conventional wisdom of their time and place, which is so often wrong. Thus, a systemic “failure of capitalism” is possible: In a “laissez-faire economic regime” capitalists could all make the same mistake. This is what Posner proves, and proves well.

But in the real world of 2008, the systemic tendency toward mistakes seems to have been caused not by any risk-insensitivity inherent to capitalism or to banking, nor by the banks’ executive-compensation systems–which, of course, are also subject to competition–but by the skewed incentives produced by particular regulations imposed on capitalism. The American amendments to the Basel rules created incentives for capitalists to buy mortgage-backed securities, tipping the risk-benefit calculations of many bankers toward what turned out to be disastrously imprudent behavior.

The regulators were human, and it turned out that their ideas about prudent behavior were wrong. Now the world is paying for their mistakes.

Jeffrey Friedman, a political scientist at the University of Texas, is the editor of Critical Review.

New York Times – Sept 11, 2009 – link to original

By ALEX BERENSON

One year after the collapse of Lehman Brothers, the surprise is not how much has changed in the financial industry, but how little.

Backstopped by huge federal guarantees, the biggest banks have restructured only around the edges. Employment in the industry has fallen just 8 percent since last September. Only a handful of big hedge funds have closed. Pay is already returning to precrash levels, topped by the 30,000 employees of Goldman Sachs, who are on track to earn an average of $700,000 this year. Nor are major pay cuts likely, according to a report last week from J.P. Morgan Securities. Executives at most big banks have kept their jobs. Financial stocks have soared since their winter lows.

The Obama administration has proposed regulatory changes, but even their backers say they face a difficult road in Congress. For now, banks still sell and trade unregulated derivatives, despite their role in last fall’s chaos. Radical changes like pay caps or restrictions on bank size face overwhelming resistance. Even minor changes, like requiring banks to disclose more about the derivatives they own, are far from certain.

Coming on the same weekend as the 11th-hour bailout of the giant insurer American International Group, and the sale of Merrill Lynch, Lehman’s failure was the climax of a cataclysmic weekend in the financial industry. In the days that followed, nearly everyone seemed to agree that Wall Street was due for fundamental change. Its “heads I win, tails I’m bailed out” model could not continue. Its eight-figure paydays would end.

In fact, though, regulators and lawmakers have spent most of the last year trying to save the financial industry, rather than transform it. In the short run, their efforts have succeeded. Citigroup and other wounded banks have avoided bankruptcy, and the economy has sidestepped a depression. But the same investors and economists who predicted, and in some cases profited from, the collapse last fall say the rescue has come at an extraordinary cost. They warn that if the industry’s systemic risks are not addressed, they could cause an even bigger crisis — in years, not decades. Next time, they say, the credit of the United States government may be at risk.

Simon Johnson, a professor at the Sloan School of Management at the Massachusetts Institute of Technology and former chief economist of the International Monetary Fund, said that the seeds of another collapse had already sprouted. If major banks are allowed to keep making bets that are ultimately backed by taxpayer guarantees, they will return to the practices that led them to underwrite trillions of dollars in bad loans, Professor Johnson said.

“They will run up big risks, they will fail again, they will hit us for a big check,” he predicted.

The doomsday view is far from universal.

Wall Street executives say the Lehman bankruptcy opened their eyes to the fragility of their institutions. They note that they have pulled back on risk and reduced leverage, creating a bigger cushion against losses. And they say that regulators were right to support the financial industry over the last year, rather than imposing new rules or allowing weak banks to collapse.

“There is less leverage in the entire financial system,” said David A. Viniar, Goldman’s chief financial officer. At Goldman, $1 in capital now supports about $14 in loans and investments, compared with $24 a year ago.

But even some senior Wall Street executives acknowledge the lack of change surprises them, given how poorly the industry performed last fall and the degree of government support necessary to keep it from collapsing.

“There was a general feeling that an enormous amount of additional regulation should be put in place to prevent what happened that weekend from happening again,” said Byron Wien, vice chairman of Blackstone Advisory Services and the former chief investment strategist for Morgan Stanley and Pequot Capital. “So far, we haven’t seen a lot of action.”

Robert J. Shiller, the Yale University economics professor who predicted the dot-com crash and the housing bust, said the window for change may be closing. “People will accept change at a time of crisis, but we haven’t managed to do much, and maybe complacency is coming back,” Professor Shiller said. “We seem to be losing momentum.”

Kenneth C. Griffin, founder and chief executive of the Citadel Investment Group, a Chicago-based hedge fund that manages $13 billion, said that regulators and lawmakers needed to impose rules so failing banks could be shut, rather than allowed to operate indefinitely with taxpayer support.

“We’ve taken a lot of steps for the worse, and not for the better, in terms of the structural underpinnings of our capital markets,” Mr. Griffin said. “We have to change the rules and correct the fundamental flaws in the financial system.”

To be sure, Wall Street is not exactly as it was before the cataclysm of last year.

Then, a dozen or so big banks formed the top tier. Now Goldman Sachs and JPMorgan Chase are clearly the strongest, with Morgan Stanley struggling to compete. Bank of America and Citigroup are the weakest big banks, heavily reliant on government guarantees to survive.

“We have more separation between the healthiest and the least healthy of the big banks,” said Darrell Duffie, a finance professor at Stanford University.

Banks have collectively raised hundreds of billions in new capital to help cushion losses on bad loans and are taking a more prudent approach to lending and underwriting. The worst excesses of 2006 and 2007, when banks lent hundreds of billions of dollars against all kinds of real estate at terms that even at the time seemed absurd, have ended.

But those changes are not unexpected. Banks typically raise lending standards during recessions. And even if they wanted to keep up underwriting, they would not find much of a market. Many pension and hedge funds have suffered huge losses on mortgage-backed bonds and are hardly rushing to buy more.

Critics of the industry argue that the pullback in risk will be only temporary without deep regulatory changes. Nassim Nicholas Taleb, a statistician, trader, and author, has argued for years that financial firms chronically underestimate their risks and must be managed much more cautiously. Universa Investments, a $5 billion fund in which he is a principal, made more than 100 percent profit last year betting on the possibility of a collapse.

Mr. Taleb warns that the system has grown riskier since last fall. The extensive government support that began after Lehman collapsed will lead investors to assume that governments will always prevent major banks from collapsing, he said.

So investors will lend money to the financial industry on easy terms. In turn, financial institutions will use that cheap money to make risky loans and trades. The banks will keep the profits when their bets pay off, while taxpayers will swallow the losses when the bets go bad and threaten the system.

Economists call the phenomenon moral hazard. Bankers have a different term: I.B.G. The phrase implies that by the time a deal goes sour, “I’ll be gone,” after having received a sizable bonus.

Despite the predictions last year about pay cuts, those bonuses appear secure. Kian Abouhossein, an analyst at J.P. Morgan in London, predicted this week that eight major American and European banks would pay the 141,000 employees in their investment banking units $77 billion in 2011 — about $543,000 per worker, not far from the 2007 peak — even after minor regulatory changes are adopted.

Because the rewards are so rich, the banks will not change unless regulators and lawmakers force them, Mr. Taleb said.

“I don’t know anyone on Wall Street who goes to work every day thinking of anything but how to increase their bonus,” he said.

To prevent a replay of last year’s crisis, investors in financial institutions, especially bondholders, must believe that they will lose money if banks fail, said Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation. “You need to send that very strong, clear signal to restore market discipline,” Ms. Bair said.

But legislation that would allow regulators to close giant institutions in an orderly fashion has been stalled for months. So too have efforts to create a systemic regulator that would focus on the broader risk that might occur from the ripple effects caused by the failure of one major bank.

Another proposed change would require banks to list and trade derivatives through a central clearinghouse, just as stocks and options are traded through exchanges, but it has yet to go anywhere.

The term derivatives encompasses a variety of financial products, including contracts whose value changes as interest rates move and insurance that pays off if a bond defaults. Derivatives drove the boom before 2008 by encouraging banks to make loans without adequate reserves. They also worsened the panic last fall because they inherently tie institutions together. Investors worried that the collapse of one bank would lead to big losses at others.

Requiring that derivatives be traded openly sounds like a relatively small change, but it could have important effects.

Exchange trading would open pricing for derivatives, so banks could not hide money-losing positions. Banks would have to put up money as positions moved against them, since the exchanges would seize and sell derivatives that were not backed by adequate margin. That move would help avoid the situation A.I.G. faced last year, after it wrote hundreds of billions of dollars of credit insurance and had no money to make good on its promises when the bonds defaulted. But critics say that even the proposed changes would not go far enough, because they would exempt some complex derivatives from exchange trading or clearing. Moreover, some banks oppose opening derivatives trading, because it would cut their profits by making pricing more visible and as a consequence competitive. For now, legislation to force derivatives trading onto exchanges has stalled, and banks are still writing contracts with limited regulatory oversight.

“The off-exchange derivatives market is still the Wild West,” Ms. Bair said.