The Devil Is in the Details

Mike Konczal at Rortybomb disagrees with Economics of Contempt's recent post in these pages about the proper regulatory structure for derivatives trading:

To put it a different way, opponents of full financial reform are saying that the a few concentrated market players can be trusted to not manipulate the clearinghouses at exactly the same moment as a few concentrated market players are being investigated by the Department of Justice for manipulating the clearinghouses. Change we can believe in!

I know what the retort is. “Mike, you know that po-po is always fucking with a working man who is just trying to hustle some (financial) product on the corner to feed his kids.” I’m sympathetic to critiques of “po-po” myself. But this was the point of the recent Slate piece on the Lynch Amendment; giving the largest players a legal ability to sit together in the same room and make rules for trading and clearing swaps at the same exact moment they are being investigated for a conspiracy to do that is a terrible idea.

Even better, Mike is not content just to hurl brickbats and criticism. He explains in an accompanying post exactly what it is he is looking for in derivatives trading reform:

Let’s define some terms. Many people are comfortable forcing OTC derivatives to be forced into clearing (though I don’t think the author above does). I like that, but I and others worried about financial reform want to see more. Let’s talk about exchanges versus clearing. Now as opposed to the FT article, I’m not saying everything needs to be forced onto an exchange proper. There are plenty of great innovations going on in the swap execution facility (SEF) world. What I am worried about is that the swap execution facility will move away from a formal “trading facility” definition towards a vague nebulous definition of whatever people can get away with.

So what are the features that I want to see? I want to see pre-trade price transparency. I want a facility where multiple parties can see and execute on offers from other parties. A facility that collects the prices at which multiple parties would be willing to trade a a moment in time, and update those prices as time passes.

“Wake Up, Gentlemen”

[This post originally appeared at The Baseline Scenario on December 15, 2009. It is reproduced here in its entirety with the kind permission of the author.]

The guiding myth underpinning the reconstruction of our dangerous banking system is: Financial innovation as-we-know-it is valuable and must be preserved. Anyone opposed to this approach is a populist, with or without a pitchfork.

Single-handedly, Paul Volcker has exploded this myth. Responding to a Wall Street insiders‘ Future of Finance “report“, he was quoted in the WSJ yesterday as saying: “Wake up gentlemen. I can only say that your response is inadequate.”

Volcker has three main points, with which we whole-heartedly agree:

1. “[Financial engineering] moves around the rents in the financial system, but not only this, as it seems to have vastly increased them.”
2. “I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy”

and most important:

3. “I am probably going to win in the end”.

Volcker wants tough constraints on banks and their activities, separating the payments system – which must be protected and therefore tightly regulated – from other “extraneous” functions, which includes trading and managing money.

This is entirely reasonable – although we can surely argue about details, including whether a very large “regulated” bank would be able to escape the limits placed on its behavior and whether a very large “trading” bank could (without running the payments system) still cause massive damage.

But how can Mr. Volcker possibly prevail? Even President Obama was reduced, yesterday, to asking the banks nicely to lend more to small business – against which Jamie Dimon will presumably respond that such firms either (a) are not creditworthy (so give us a subsidy if you want such loans) or (b) don’t want to borrow (so give them a subsidy). (Some of the bankers, it seems, didn’t even try hard to attend – they just called it in.)

The reason for Volcker’s confidence in his victory is simple - he is moving the consensus. It’s not radicals against reasonable bankers. It’s the dean of American banking, with a bigger and better reputation than any other economic policymaker alive – and with a lot of people at his back – saying, very simply: Enough.

He says it plainly, he increasingly says it publicly, and he now says it often. He waited, on the sidelines, for his moment. And this is it.

Paul Volcker wants to stop the financial system before it blows up again. And when he persuades you – and people like you – he will win. You can help – tell everyone you know to read what Paul Volcker is saying and to pass it on.

By Simon Johnson

The Lynch Amendment: Bizarre and Confused

[This post originally appeared at Economics of Contempt on December 15, 2009. It is reproduced here in its entirety with the kind permission of the author.]

The Lynch amendment has to be one of the most bizarre pieces of legislation relating to derivatives I've ever seen—and that's saying something. Really, the amendment is just illogical. Introduced by Rep. Stephen Lynch, the amendment prohibits swap dealers and "major swap participants" from owning more than 20%, collectively, of a derivatives clearinghouse. Here's how Rep. Lynch justified his amendment on the House floor:

[T]he problem is—and in my view, this is a huge problem with the bill—the bill would allow these same big banks to purchase the clearinghouses that are being created to police the big banks in their derivatives trading. The big banks would be allowed to own and control the clearinghouses and to set the rules for how their own derivatives deals are handled. My amendment would prevent those big banks and major swap participants, like AIG, from taking over the police station—these new clearinghouses.

This makes absolutely no sense. Rep. Lynch appears to be deeply confused about both clearinghouses and the derivatives market. Unfortunately, the Lynch amendment has been cheered on by the blogosphere, which now reliably swoons at any mention of hurting "Wall Street," seemingly without regard for the merits of the proposal.

Honestly, what do supporters of the Lynch amendment think clearinghouses are? The purpose of a clearinghouse is risk mutualization. If one clearing member defaults on a cleared contract, the other members—via the clearinghouse—will pick up the tab. That's why the clearinghouse, as the central counterparty (CCP), interposes itself between counterparties to contracts cleared through the clearinghouse, serving as the buyer to every seller and the seller to every buyer. The whole purpose of this set-up is to put all the clearing members on the hook for one clearing member's default. (If after applying a defaulting member's margin account, the money the other clearing members have contributed to the clearinghouse's guaranty fund still isn't sufficient to cover the losses from a member's default, the clearinghouse can generally force the other clearing members to make one-time contributions to cover the remaining losses.)

A Few Things Worth Considering

From one of the more underrated political philosophers and students of human nature of our time:

Governments, if they endure, always tend increasingly toward aristocratic forms. No government in history has been known to evade this pattern. And as the aristocracy develops, government tends more and more to act exclusively in the interests of the ruling class — whether that class be hereditary royalty, oligarchs of financial empires, or entrenched bureaucracy.

* *
Good government never depends upon laws, but upon the personal qualities of those who govern. The machinery of government is always subordinate to the will of those who administer that machinery. The most important element of government, therefore, is the method of choosing leaders.

* *
What you of the CHOAM directorate seem unable to understand is that you seldom find real loyalties in commerce ... Men must want to do things of their own innermost drives. People, not commercial organisations or chains of command, are what make great civilizations work, every civilization depends upon the quality of the individuals it produces. If you overorganize humans, over-legalize them, suppress their urge to greatness — they cannot work and their civilization collapses.

— Frank Herbert, Children of Dune

All laws and regulations are only as good as the people who create, interpret, and implement them. Given the dominant strains of careerism, materialism, and narcissism among our current socioeconomic elites, this observation falls squarely on the side of those who counsel cynicism and despair.

In the long run, the biggest challenge we face is not writing new laws and regulations, but rather choosing better leaders. We might approach this project first by figuring out how to raise better humans.

Ah, if only it were that easy ...

© 2009 The Epicurean Dealmaker. All rights reserved.


[This post originally appeared at The Epicurean Dealmaker on December 14, 2009. It is reproduced here in its entirety.]

Finreg I: Bank capital and original sin

[This post originally appeared at interfluidity on December 11, 2009. It is reproduced here in its entirety.]

I have always flattered myself that I would someday die either in prison or with a rope around my neck. So I was excited when The Epicurean Dealmaker invited me to write about financial regulation and crosspost at a site called The New Decembrists. But my views on the topic have grown both more vehement and more distant from the terms of the current debate (such as it is), and I'm having a hard time expressing myself. So I'll ask readers' indulgence, go slowly, and start from the beginning. This will be the first long post of a series.

---

Banks are not financial intermediaries. Their role is not, as the storybooks pretend, to serve as a nexus between savers with capital and entrepreneurs in need of capital for economically valuable projects. Savers do transfer funds to banks, and banks do transfer funds to borrowers. But transfers of funds are related to the provision of capital like nightfall is related to lovemaking. Passion and moonlight are often found together, yes, and there are reasons for that. But the two are very distinct phenomena. They are connected more by coincidence than essence.

The essence of capital provision is bearing economic risk. The flow of funds is like the flow of urine: important, even essential, as one learns when the prostate malfunctions. But "liquidity", as they say, takes care of itself when the body is healthy. In financial arrangements, whenever capital is amply provided — whenever there is a party clearly both willing and able to bear the risks of an enterprise — there is no trouble getting cash from people who can be certain of its repayment. Always when people claim there is a dearth of "liquidity", they are really pointing to an absence of capital and expressing disagreement with potential funders about the risks of a venture. Before the Fed swooped in to provide, 2007-vintage CDOs were "illiquid" because the private parties asked to make markets in them or lend against them perceived those activities as horribly risky at the prices their owners desired. There was never an absence of money. There was an absence of willingness to bear risk, an absence of capital for very questionable projects.

No economic risk is borne by insured bank depositors. We have recently learned that very little economic risk is borne by the allegedly uninsured creditors of large banks, and even equityholders — preferred and common — have much of the risk of ownership blunted for them in a crisis by terrified governments. The vast, vast majority of bank capital is therefore provided by the state. Prior to last September, uninsured creditors of US banks were providing some capital. Though they relied upon and profited from a "too big to fail" option when buying bonds of megabanks, there was some uncertainty about whether the government would come ultimately come through. So creditors bore some risk. During the crisis, private creditors wanted out of bearing any of the risk of large banks. Banks were illiquid because private parties viewed them as very probably insolvent, and were unsure that the state would save them.

For Every Action ...

[This post originally appeared at The Epicurean Dealmaker on December 10, 2009. It is reproduced here in its entirety.]

Christopher Columbus: "Hello there, hello there. Heh, heh. Ahh ... We white men. Other side of ocean. My name ... Chris-to-pher Co-lum-bus."
Indian chief: "Oh? You over here on a Fulbright?"
Christopher Columbus: "Hah? Uh, no, no. I'm over here on an Isabella, as a matter of fact. Which reminds me: I wanna take a few of you guys back with me in the boat to prove I discovered you."
Indian chief: "What you mean, discover us? We discover you."
Christopher Columbus: "You discovered us?"
Indian chief: "Certainly. We discover you on beach here. Is all how you look at it."
Christopher Columbus: "Ah, I never thought of that."

— "Columbus Discovers America," Stan Freberg Presents the United States of America, Vol. 1: The Early Years

It looks like Alistair Darling is going to have a quiet Christmas.

The UK finance minister unveiled a nasty Christmas surprise for bankers in the City yesterday: a 50%, non-deductible tax on discretionary bonuses in excess of £25,000 (or $41,000), to be levied against their employers' net income. This scurrilous government attack against chalk stripe suits, Soho strip clubs, and London property values landed with a sickening thud in Old Blighty. Many a banker's wife summarily cancelled their holiday plans and started contacting real estate agents in Geneva.

Today, Nicolas Sarkozy of France had the unmitigated gall (Unmitigated Gaul?) to pile on with a parallel policy proposal for his country's budget and an editorial in The Wall Street Journal, co-authored with famously dyspeptic Scot Gordon Brown. The fact that France agrees with the UK and is proposing a similar policy is proof positive that either La Republique has been secretly taken over by a stunted Englishman pretending to be French or the UK's Labour government is so desperate to retain power that it's turning Gaullist. Probably both.

In any event, the policy—as do all new tax policies at the end of the day—has triggered a desperate surge of scurrying about by bankers and banks, as they attempt to discover ways out of the trap. Their prospects do not look good.

London contacts report senior investment bankers stacked three deep on the pavement outside advisory boutiques' offices this morning, banging on the custom paneled mahogany doors to get entrance for interviews. One Vice President remarked he hadn't seen that many bespoke suits in one place since he stumbled into Gieves and Hawkes' basement storeroom on Saville Row by mistake. I predict independent UK advisors will quintuple their headcount by Christmas.

Other Voices – December 8, 2009

Where else could Kashkari have gone?, Felix Salmon. Neel Kashkari flees the woods (literally) for PIMCO:

Now it’s entirely possible that Kashkari went to Treasury out of pure selflessness — but he’s blazed a trail now (or at least he would have done had he not been following in the footsteps of many who went before him) and in future anybody moving to Treasury can expect that doing so is liable to do wonders for their employability and their chances of ever making a seven-figure income.

Hmm. Jumping into the welcoming embrace of the private sector so soon after leaving one of the most powerful and undefined governmental roles in financial history does seem a little ... unseemly. Perhaps my suggestion for a merged SEC and CFTC that we should "[d]ouble or triple ... professionals' pay, and impose a minimum five-year ban on joining any financial services provider after leaving the agency" should apply to Treasury, too.

A Windfall Profits Tax for Goldman Sachs?, Steven Davidoff, The Deal Professor. Provocative, to say the least. I worry that I have become excessively attracted to punitive, one-off solutions to intransigent structural problems. Must be my inner Bolshevist asserting itself.

Compromising my values every day, for you., Ultimi Barbarorum. Baruch defends financial markets as excessively complicated and sensitive emergent phenomena unsuitable for clumsy tampering. I think he also argues against a transaction (or Tobin) tax in there somewhere, but I seem to have misplaced my extensive notes.

Build It, and They Will Come

Mike Konczal over at Rortybomb¹ has weighed in this morning on my reformist manifesto. For the most part, he does not seem to have disagreed with me overmuch, which is either a sign that I am on the right track or that Mike is too much of a gentleman to reveal to the world that I am a hopeless idiot. I prefer to believe the former, despite all evidence to the contrary.

Anyway, he specifically comments on a handful of my proposals. While I do not disagree with the substance of his remarks, I thought it would be useful to respond in this forum with a few clarifications and comments of my own. He repeats my proposals in bold and comments below:

2) Narrow and focus the role of the Federal Reserve…3) Render Fed actions and deliberations transparent.

To me this is an either/or. If the Fed wants to be the systematic risk regulator and use its 13 (3) privileges in an expansive manner going forward, there needs to be a change in the way they are monitored. I understand 13 (3) goes back 70 years, but given that the Fed will use these privileges more aggressively in the future then they need to be monitored in an equally aggressive manner. Removing these regulation powers to outside the Fed (as the Dodd Bill currently proposes), means that there isn’t quite the same need for transparency (though the way appointments are made could stand to be reformed either way).

I think we really agree here. My proposal is to narrow the Fed's mandate to its core responsibility for monetary policy and price stability but add "responsibility for monitoring, controlling, and managing systemic financial risk." If we commission the Fed to act as our overall systemic regulator, as I suggest, of course we should increase legislative oversight of it. It is exactly the sort of non-monetary policy decisions like the Fed made in the case of AIG and others recently that must be examined in retrospect under a clear and searching light. Just reassign the Fed's other responsibilities for consumer protection etc., which it has sadly neglected, to other parties. Monetary policy, as far as I am concerned, can remain largely unexamined and protected from political interference in the deep dark hole where it has resided for decades.

We Didn't Start the Fire

[This post originally appeared at The Epicurean Dealmaker on December 7, 2009. It is reproduced here in its entirety.]

Rob Slolom: "Wow. Eight Oscars, 400 million dollars at the box office, and you saved Tugg Speedman's career."
Les Grossman: "I couldn't have done it without you."
Rob Slolom: "Really?"
Les Grossman: "No, dickhead. Of course I could. A nutless monkey could do your job. Now, go get drunk and take credit at all the parties."
Rob Slolom: "I wouldn't do that."
Les Grossman: "Ah ... joking. "
Rob Slolom: "Ah, there he is! Funny. You're a funny guy."
Les Grossman: "Yeah. But seriously, a nutless monkey could do your job."

— Tropic Thunder

For what it is worth, O Dearly Beloved, you cannot count me among the rabid, spittle-flecked populists who lump private equity plutocrats in with venal investment bankers, clueless commercial bankers, meretricious mortgage brokers, and Nancy Pelosi's manicurist as the principal agents of our current economic desuetude. While it is true that many of these would-be Captains of Industry did purchase companies at preposterously high valuations in 2006 and 2007 at the orgiastic climax of the Sino-Greenspan credit bubble, the most the majority of these hapless boobs can be accused of is getting their wee-wees caught in the woodchipper of mistaken opportunity.

Vast herds of professional morons in the fixed income investor community apparently thought it was a brilliant idea to offer virtually limitless quantities of debt at virtually invisible interest rates with virtually zero credit protection to picayune ex-investment bankers so the latter could snap up the flower of American (and global) industry at 250% of retail. With limited exceptions, said PE types said "What the hell," and signed on the dotted line. After all, their fiduciary and professional duty to their own investors is simply to maximize returns on contributed capital. And, in the unexpected case their investments went belly up, the PE professionals and their limited partners could just hand over the keys to the failed portfolio companies to their embarrassed lenders. What was not to like?

Of course, many of the overlevered companies owned by private equity firms are now struggling or have failed entirely. Hundreds if not thousands of employees who worked at these investments have been laid off, and thousands if not millions of citizens whose pension funds or universities invested in their shitty debt have taken it in the neck. But caveat emptor, eh?

Put a Sock in It

Ooh, this is getting fun.

An unnamed bloggist at Salon.com has picked up my anti-Constitutional ball and is running with it. In a post this morning entitled "It's time for Wall Street to just shut up," (s)he gives more background on the reasoning behind the first proposal from the reformist agenda I posted here recently:

Yes, constitutional freedom of speech protections apply even to banks. But the system is clearly broken

The Epicurean Dealmaker has posted a ten-point manifesto for regulatory reform. Everything on it makes sense to me, starting with point one:

1) Ban political campaign contributions by the financial industry.

At The Baseline Scenario James Kwak observes that "there is at least one constitutional problem and possibly two" involved in the recommendation. That's a non-trivial issue.

But the financial industry's influence on legislation is equally non-trivial. There's got to be a better way. Check out the bombshell in Michael Hirsh's new Newsweek piece on Barney Frank and the perils of crafting new regulations for derivatives trading

Revolution and Reform

[This post originally appeared at The Baseline Scenario on December 7, 2009. It is reproduced here in its entirety with the kind permission of the author.]

Many of us bloggers are better at criticizing than at proposing anything — especially when the world makes it so easy to be a critic. The Epicurean Dealmaker, who has sent the occasional volley of criticism my way (I’m not linking to examples because my ego is too fragile), recently decided to deal with this head-on and wrote a “reformist manifesto,” complete with an epigraph from The Communist Manifesto, with a list of specific proposals.

Basically these include cleaning up the regulatory structure, expanding the scope of regulation (consumer protection, hedge funds), moving “virtually all” OTC derivatives onto exchanges or clearinghouses (I believe that “virtually all” means the currently-proposed exemption for “end-user” hedges would be drastically reduced), and increasing Fed transparency. There is also this one: “Ban political campaign contributions by the financial industry.” I think that would be great, although there is at least one constitutional problem and possibly two there.

There’s nothing on the list that I disagree with.

Cap This!

Lest we forget that the recent financial crisis has imposed real costs on the real economy, Simon Johnson of The Baseline Scenario reminds us, at length.

He claims that bailing out financial institutions considered too big or too connected to fail was the principal vector in the recent contagion, and he asserts we will have fixed nothing if we do not fix this:

9) At the heart of every crisis is a political problem – powerful people, and the firms they control, have gotten out of hand. Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout. That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term. Again, this is the problem in the U.S. looking forward.

And in Europe, too, a point which Mr. Johnson makes as well.

His solution? Explicitly limit the size of financial institutions through the imposition of hard caps:

Punish the Monkey (and Let the Organ Grinder Go)

[Submitted by Josh Brown of The Reformed Broker]

The boss has hung you out to dry
And it looks as though
they'll punish the monkey
and let the organ grinder go

— Mark Knopfler, Punish the Monkey

When ex-Dire Straits frontman Mark Knopfler put the song "Punish the Monkey" on his 2007 masterpiece solo album, he probably had no idea how prescient its lyrics would soon become.

When I think about the next wave of regulation headed toward a brokerage firm or a bank near you, my main hope is that the rule-makers are focused on the "organ grinders" themselves rather than on the proverbial monkey. The monkey, who has merely been dancing to the only tune available, has the most to lose in a regulatory overhaul. It is the organ grinders who can usually find a way to keep the largest portion of the profits toward the top of the the organizational structure, even in restrictive environments.

While you cannot legislate every instance of unrestrained greed, avarice, recklessness and fecklessness out of existence on an individual basis, you can certainly make laws to prevent entire corporations and industries from the mass adoption of these non-virtues.

To single out one or two groups of the financial-industrial complex (say, traders or advisors) for extinction-level scrutiny would be to ensure that the next great scandal arises out of the intent of some to subvert the new rules.

From the Editor

Dear Readers, Collaborators, and Commenters —

As the financial Panic of 2008 recedes in our collective rearview mirror, this author has become increasingly interested in and engaged with the debate surrounding the proper shape and content of financial reform. While I am no expert in the regulation of financial services—nor indeed in almost any of the cognate fields which inform, impinge upon, and affect financial regulation—I am a practitioner in one financial subsector which, for better or worse, has played a central role in the panic and its aftermath; namely, investment banking.

Having practiced M&A and corporate finance within investment banks for approximately two decades, I have an insider's perspective on certain aspects of financial regulation on which many, many people—ranging from exceedingly well-informed and erudite all the way to woefully and stubbornly ignorant—have begun to opine. I myself have many opinions, prejudices, and predilections for what I believe the new regulatory framework for the financial system should look like, and I have shared several of those thoughts on my own blog site on occasion.

The New Decembrist Manifesto

On December 14, 1825 (old style), according to Wikipedia, officers of the Imperial Russian Guard

led about 3,000 soldiers in a protest against Nicholas I's assumption of the throne after his elder brother Constantine removed himself from the line of succession. Because these events occurred in December, the rebels were called the Decembrists (Dekabristy, Russian: Декабристы). This uprising took place in the Senate Square in Saint Petersburg.

The loyal soldiers who became known as the Decembrists held many divergent views, and they cannot be said to have pursued a unified program of change. However, they were united by two fundamental beliefs: they wished to increase social, legal, and economic justice; and they wished to change the existing Russian political system through reform, not revolution.

It is in this spirit that this site appropriates their name. Winston Churchill famously proclaimed:

Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried from time to time.

We would like to say the same about capitalism as a form of economic organization. We do not seek revolution, or the destruction of what we currently have. We seek only to fix it, to make it better than it was. How we should do that, however, is a proper subject for debate.

Please join the conversation.

A Reformist Manifesto

[This post originally appeared at The Epicurean Dealmaker on December 3, 2009. It is reproduced here in its entirety.]

The Communists disdain to conceal their views and aims. They openly declare that their ends can be attained only by the forcible overthrow of all existing social conditions. Let the ruling classes tremble at a Communistic revolution. The proletarians have nothing to lose but their chains. They have a world to win.

Working Men of All Countries, Unite!

— Karl Marx and Friedrich Engels, Manifesto of the Communist Party

It has not escaped my notice, O Estimable and Valued Readers, that you have displayed remarkable patience with Your Dedicated Correspondent over the last many moons of the ongoing financial crisis and its aftermath. I have ranted, I have railed, and I have hopped up and down spluttering like a one-legged kangaroo rat on a hotplate over the many failures of our present regulatory system to have avoided or even anticipated the financial tsunami which rolled over us. "Sure," I have seen you mutter to yourself, "TED has fulminated rather spectacularly about what went wrong, and how idiots, nincompoops, and boobs of every stripe screwed the pooch, but what does he suggest? Does he have any ideas, or is he merely content to take potshots at financiers, regulators, and politicians and leave it at that?"

This is a fair question, and I think you deserve an definitive answer. Being none other than who I am, however, you can rightly expect that I will give it to you with both barrels. Subtlety and nuance be damned.

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