Streetwise Professor

Oil was down almost 10 percent today, following the decline in equities.  But that’s not what I find intriguing.  What I find intriguing is that the price of oil was able to rise above $50/bbl, and stay there for awhile, despite extremely weak fundamentals.

These two FT Alphaville blog posts set out the story in detail.  They document continuing increases in inventories.  Specifically, both crude inventories and refined product inventories have been continuing their increase even as prices have inched upwards.  The increase in US refined plus crude stocks is a 4 standard deviation move–bigger than observed in almost 30 years.  Tanker rates are falling even as firms are chartering both clean and dirty tankers to store products and crude.  Refinery capacity utilization is at very low levels.

In a conventional theory-of-storage model, the increase in inventories would reflect a decline in demand/increase in supply that would also result in lower prices; the accumulation of inventories would slow, but not stop, the decline in prices.  Given that supply has actually dropped (due to OPEC output cuts), this would mean that demand has continued its precipitous drop.  

In the past I’ve argued that inventories and prices can move in the same direction when fundamental uncertainty increases.  An increase in fundamental volatility leads to increases in precautionary inventory holding.  The only way to accommodate this demand for higher inventories is to raise prices.

But that doesn’t seem to be a plausible explanation of what’s been happening in the last couple of months.  Some indicators of fundamental uncertainty, such as the VIX equity volatility index and credit spreads have actually eased in past months while the oil price was rising.  

So that leads me to another explanation, similar to the one advanced by the Diapason Commodities guy quoted in one of the FT pieces: Inflationary expectations.    

So what was behind the recent strength in crude prices? According to Corrigan most likely the same thing that was behind the equity rally – people investing in commodities and ‘real assets’ as an inflation hedge. As he explains:

This inflationary policy is already beginning to push people towards increasing their exposure to real assets — hence the rise in commodities and stocks   – a phenomenon very similar   to that which took place after the American devaluation of 1933, well ahead of the recovery in real output.  

Given the dismal news about the real economy, that’s the only thing that makes sense to me (in both the equities and commodities markets).  (Though Chinese strategic inventory accumulation is probably playing a role too.  That could be seen as inflation related too, however, as it involves the Chinese exchanging nominal claims, US dollar denominated securities, for real commodities.  That is a reasonable response to inflationary expectations; tends to reduce the demand for dollars; and cause an appreciation in the dollar prices of real commodities.  It is a Chinese contribution to quantitative easing.)  

You might say: “But the CPI and PPI actually dropped last month.  Inflation is the least of our worries: deflation is a more pressing concern.”  I would argue that these price measures are backwards looking; asset and commodity markets are forward looking.  And looking forward, there are many signs pointing to a potential spike in inflation.  It is not a probability one event, but the huge monetary overhang poses acute challenges to the Fed, and other central banks that have engaged in quantitative easing.  If they do not walk a very fine line, inflation could very well flare up.  And the line will be very hard to walk, because of the politicization of the Fed and other central banks, and the inherent credibility problem in anti-inflation policies as economies pull out of recession/depression/banana (a reference to Alfred Kahn’s quip in the 70s).  Therefore, it is not surprising to me that the dollar value of equities and commodities has strengthened somewhat recently.  

I will be keeping an eye on the connection between commodity prices and measures of fundamentals, especially inventories and capacity utilization.  Bearish fundamentals plus firming prices are a strong signal of potential stagflation.

A brief comment about today’s equity selloff.  I was actually surprised at the rally in stocks in recent weeks on bank earnings news.  I was surprised because I thought these earnings announcements said nothing about the main issue involving banks–the values of the assets in their portfolios.  Making money trading in an illiquid environment with wide bid ask spreads (because many competitors have exited the market), and intermediating in a market with a relatively steep term structure, is no surprise.  But what inquiring minds want to know is whether the banks are really solvent or not, and the answer to that question depends on the performance of all the bad assets.  It appears that today’s decline was related directly to inferences about the continued, and perhaps increasing, severity of this problem.  Inferences derived from reading between the lines in various bank earnings statements.  

For my part, I am paying little attention to bank earnings.  I am looking for clues about solvency.  And today suggests that the market is adopting a similar approach.

A succinct description of the fundamental flaw of autocratic regimes.

This is by George Handlery, and is about Russia specifically:

Could it be? The instinct-driven policy objective of Russia for more recognition as a major world power, is realizable only if pursued by system akin to that of the Tsars or the Commissars. In this case, the limited existing resources allotted by lacking development   (not the country’s unused potential) need to be enhanced by dictatorial methods. These can concentrate the available means to overcome qualitative handicaps. Essentially, like the sun’s ray’s are concentrated by a magnifying glass, “limited” resources become bundled by dictatorship to achieve maximal effect at a chosen point. The problem with using autocracy as a multiplier of laggard means pit against an advanced opponent, are twofold. (A) It diverts energies from stimulating general internal advancement for the pursuit of domination abroad. Thereby the developmental lag is perpetuated. (B) Playing a power-role not commensurate to the country’s comparative modernization, and not corresponding to her development, risks destroying the system. (World War One, Cold War.)

I’ve said very similar things before, just never so well, or so pithily.  

There are no better illustrations of Handerly’s point than Russia’s insistence on (a) re-asserting its dominance in the near abroad (see, for instance, this article about a foiled Nashi influence (provocation?) operation in Georgia), and (b) increasing defense spending dramatically at a time when the Finance Ministry sees the necessity of cutting the budget between 10 and 30(!) percent in 2010.  Talk about attempts to ” to play a power-role  not commensurate to the country’s comparative modernization, and not corresponding to her development” that  “risks  destroying the system.”

Like I say–like the Bourbons: learned nothing, forgot nothing.  Or, to use a military expression: reinforcing failure (a cardinal military sin).  And doing so at a time when every resource is desperately needed to fight a crisis at home.  

On the one hand, this is stunningly bizarre.  On the other, as Handerly suggests, it is hardwired into the authoritarian mindset.  And we’ve seen of course–multiple times, in fact–how this plays out.  It isn’t pretty.

Not me.  Alexei Kudrin.  Putin says so, as a way of dismissing Kudrin’s increasing pessimism, which contradicts Putin’s happy talk on the Russian economy.  Given Kudrin’s vital role as Horatius at the Gate; the fact that he is one of the few economically literate people in the Russian leadership; and the fact that various siloviki have had their knives out for Kudrin and their eyes on the treasures he guards; this could be a very important development.

This comes as evidence of strains and severe differences of opinion  within the Russian leadership  over the economy and measures to address it are becoming very public.  The most obvious evidence comes from the Reuters article linked above, headlined “Russian Ministers Clash Over Crisis Time Tax Plans”:

Russia’s top economic decision makers clashed on Wednesday over whether some taxes should be cut to help business through the first recession in a decade, or whether the budget cannot afford to lose any more revenue.

Officials painted a fairly glum picture of the oil-dominated economy, saying the economy could contract more than 7 percent in the first quarter of this year, while consumption is falling and the difficult times could last for the next three years.

In an early indication of a significant downturn, Russia’s statistics service later reported a 13.7 percent industrial output slump in March in year-on-year terms, the second biggest decline since 2002.

President Dmitry Medvedev has urged officials to present a united front on the crisis, but cracks are starting to show.

. . . .

The fiscally prudent Kudrin on Tuesday warned Russia should not expect a return of the favorable conditions it has enjoyed in the recent years for the next “five, 10, 20 or 50 years.”

On Wednesday, Kudrin warned tax cuts would further undermine falling budget revenues in such a climate.

But the Economy Ministry, which focuses on longer-term development, and an influential Kremlin aide said lower levies may be needed to maintain competitiveness. “For business as a whole … I agree, we should not increase the financial burden, not even in 2011,” top Kremlin economic aide Arkady Dvorkovich told the Russian Union of Industrialists and Entrepreneurs (RSPP).

. . . .

“This is my personal forecast … but I think that some decision to cut VAT could be expected from 2011,” he said.

Economy Minister Elvira Nabiullina echoed his comments.

“We think we should not increase the total tax burden on businesses, especially at the time of crisis,” she told the same meeting. “We can propose reforming the tax system … We need to stimulate spending on innovation, social spending.”

COLD WATER

Finance Minister Kudrin, who spoke after Dvorkovich and Nabiullina, discarded their suggestions as populist.

“If we talk about the coming years, then we have not completed the analysis of how the government will function in the conditions of new revenues,” Kudrin said.

“I think my colleagues did not calculate, did not weigh up and made statements for the public.”

He added that the 2009 budget revenues forecasts now looked “optimistic,” while the economic contraction for the first three months of the year could be deeper than the expected 7 percent.

Earlier this week, Kudrin said Russia should slash its 2010 budget revenue forecast by more than 30 percent and cut planned expenditures by 13 percent, or $39 billion. He also said the state could borrow abroad for the first time in a decade.

The background for this, alluded to in the article, is that (a) the GDP contraction in the first quarter was more severe than anticipated, perhaps greater than 7 percent, (b) industrial production contracted by a larger than expected 13.7 percent year-on-year in March  (the industrial production decline was more  severe than forecasts by economists polled by Bloomberg (12.5) and reported in  Forbes  (12.3 percent)),and (c) dire alarums have been heard emanating from three major Russian banks, VTB, Sberbank, and Alfa Bank, about the prospects for a tsunami of loan defaults in the coming months.  

It should also be noted that there are those among the siloviki who agree with Kudrin’s gloomy prognosis:

Railway cargo turnover, a key indicator of the trend in industry, fell 15.8 percent in March from a year earlier, compared with a 26 percent fall in January,  Vladimir Yakunin, chief executive officer at rail monopoly OAO Russian Railways, said in a Bloomberg Television interview on April 6.

“We are only at the beginning of the crisis,” Yakunin said.

Yakunin’s OAO Russian Railways is apparently in a dispute with steelmakers over agreements to purchase rails.  OAO RR wants to cut back purchases dramatically.  The steelmakers claim they have a deal.

The debate between Kudrin,  Dvorkovich and Nabiullina illustrates Russia’s policy dilemmas: they may all be right.  Kudrin may be right in the sense that the weak economy so imperils the government’s financial condition that it cannot afford a tax cut.  Dvorkovich and Nabiullina may be right in the sense that without some relief, Russian companies will struggle to survive.  Like a failing city with a plummeting tax base (e.g., Detroit, St. Louis), Russia can’t afford to cut taxes, and it can’t afford to keep them high, either.  

But the most interesting aspects of this are two.  One is that Medvedev has been relatively silent on these issues, his most notable remarks of late being some blather about the prosperity-freedom trade-off debate.  That is, for the most part, in the realm of political philosophy, and suggests some detachment from dealing with the immediate crisis.  

The other aspect is even more interesting than Medvedev’s apparent detachment.  That is Putin’s remark about Kudrin’s stress.  Maybe it was just a way of deflecting questions about the substance of Kudrin’s prognosis for the Russian economy.  But, given that it was not uncommon for high level Soviet officials who had become embarrassing in some way to “retire” for health reasons, there may be much more to it than that.  The “stress” remark lays the groundwork for Putin to shunt aside Kudrin if the differences between Putin’s assessment and Kudrin’s evokes so much cognitive dissonance in Russia that the Finance Minister’s continued presence becomes intolerable to the Prime Minister.  

Whether this happens or not is partly dependent on the path of the Russian economy, and government finances, in the coming weeks and months.   Stabilization or improvement would raise the odds of Kudrin’s survival.  But if his predictions turn out to be accurate, over the side he could go.  Thus, his departure would be a signal of the dire straits of the Russian economy, while at the same time removing from the scene the person most capable of handling these economic trials.  This would represent a double disaster for Russia, so it bears close watching.

Great News!  All is not well between Russia and Turkmenistan.  Although happy talk emanated from Moscow in the aftermath of  Turkmenistan President Gurbanguly Berdymukhammedov’s state visit to the Rusisian capital, developments in the weeks following the visit are definitely not to Putin’s and Medvedev’s liking:

Turkmenistan has delivered its clearest statement to date that it wants to see the development of a direct gas export pipeline system to carry thecountry’s gas to European markets.

A commentary on the official Turkmenistan.ru web site on Saturday  stressed the importance of “the shortest and most convenient routes” to new markets, but it did not directly say that Turkmenistan was looking for either a trans-Caspian gas pipeline to Azerbaijan or its onward connection to Europe via the Caucasus. Instead it spoke of the need for “diversification of energy supply and involvement of new countries and regions in the geography of energy routes.”

“The statement is a clear indication that the Turkmens are looking much more actively to Europe,” Dr Jennifer Coolidge, Executive Director of Caspian and Gulf Consultants, which specializes in analysis of Turkmen energy affairs,said.

The statement was unexpected because it came just a few days after Turkmenistan President Gurbanguly Berdymukhammedov visited Moscow for talks which Russia announced had paved the way for joint development of a new $1.2 billion East-West pipeline within Turkmenistan.

In an apparent reference to Russia’s halting of all gas exports to Europe via Ukraine on January 7, the statement said new routes were needed “to diversify supply of Turkmen natural gas and build the reliable and stable system to transit Turkmen energy to international markets.”

The foreign ministry commentary also indicated Turkmenistan’s unhappiness over price negotiations with Russia. The statement attacked the idea that international consortiums of gas producers should serve as “supranational  regulators of the price policy” — an apparent criticism of Russia’s work in promoting the Gas Exporting Countries Forum – and specifically attacked monopoly practices in gas trade whilst praising competition.

“The only true scheme to fix the natural gas prices is direct agreements between sellers and buyers,” the statement said.

Turkmenistan has a particular dispute with Russia in this regard, as Turkmen gas has been a staple of Ukraine’s gas supply for decades. But in recent years Turkmenistan has had to sell this gas to intermediary Russian  companies — first Itera, then EuralTransGas and currently RosUkrEnergo –only to see Russia then selling this Turkmen gas on to Ukraine at much higher prices.

Dr Coolidge considered that the sharp tone of the statement should be considered a declaration by Turkmenistan that it was not prepared to have its policies determined by Russia on either the issue of export routes or the price for Turkmen gas exports.

“Coming immediately after the Moscow visit, it is a clear indication of sending Turkmen gas to Europe directly and of securing greater independence on pricing.” she said.

She added that Turkmenistan remains concerned as to whether it will in fact receive the price for 2009 deliveries that it had negotiated with Russia  before the Ukraine dispute in January.

Turkmenistan has delivered its clearest statement to date that it wants to see the development of a direct gas export pipeline system to carry thecountry’s gas to European markets.

A commentary on the official Turkmenistan.ru web site on Saturday  stressed the importance of “the shortest and most convenient routes” to new markets, but it did not directly say that Turkmenistan was looking for either a trans-Caspian gas pipeline to Azerbaijan or its onward connection to Europe via the Caucasus. Instead it spoke of the need for “diversification of energy supply and involvement of new countries and regions in the geography of energy routes.”

“The statement is a clear indication that the Turkmens are looking much more actively to Europe,” Dr Jennifer Coolidge, Executive Director of Caspian and Gulf Consultants, which specializes in analysis of Turkmen energy affairs,said.

The statement was unexpected because it came just a few days after Turkmenistan President Gurbanguly Berdymukhammedov visited Moscow for talks which Russia announced had paved the way for joint development of a new $1.2 billion East-West pipeline within Turkmenistan.

In an apparent reference to Russia’s halting of all gas exports to Europe via Ukraine on January 7, the statement said new routes were needed “to diversify supply of Turkmen natural gas and build the reliable and stable system to transit Turkmen energy to international markets.”

The foreign ministry commentary also indicated Turkmenistan’s unhappiness over price negotiations with Russia. The statement attacked the idea that international consortiums of gas producers should serve as “supranational  regulators of the price policy” — an apparent criticism of Russia’s work in promoting the Gas Exporting Countries Forum – and specifically attacked monopoly practices in gas trade whilst praising competition.

“The only true scheme to fix the natural gas prices is direct agreements between sellers and buyers,” the statement said.    Turkmenistan has a particular dispute with Russia in this regard, as Turkmen gas has been a staple of Ukraine’s gas supply for decades. But in recent years Turkmenistan has had to sell this gas to intermediary Russian  companies — first Itera, then EuralTransGas and currently RosUkrEnergo –only to see Russia then selling this Turkmen gas on to Ukraine at much higher prices.

Dr Coolidge considered that the sharp tone of the statement should be considered a declaration by Turkmenistan that it was not prepared to have its policies determined by Russia on either the issue of export routes or the price for Turkmen gas exports.

“Coming immediately after the Moscow visit, it is a clear indication of sending Turkmen gas to Europe directly and of securing greater independence on      pricing.” she said.

She added that Turkmenistan remains concerned as to whether it will in fact receive the price for 2009 deliveries that it had negotiated with Russia      before the Ukraine dispute in January.

She said the consideration of new routes “fits into the discussions that the Turkmen authorities have been having with Austria’s OMV and Germany’s RWE on a Caspian Energy Corp.”

The Caspian Energy Corp.’s stated aim is to assess prospects for development of a trans-Caspian gas pipeline. This would then be able to hook into the existing South Caucasus Pipeline from Azerbaijan to Turkey, enabling it to connect up with the planned Eur7.9 billion ($10.6 billion) Nabucco pipeline project, in which both companies are also involved.

The EU-backed Nabucco pipeline is intended to carry Caspian gas on strictly commercial terms all the way to the Austrian hub at Baumgarten, with European Union officials specifically arguing that Nabucco should be seen as a way of attracting large volumes of gas — eventually as much as 60-120 Bcm/year — from Turkmenistan, as well as Azerbaijan, to Europe.

During Berdymukhammedov’s Moscow visit, an aide to Russian President Dimitry Medvedev said March 25 that the two presidents would sign during one of their future meetings an agreement on developing a major internal pipeline intended to connect the giant South Yoloten field with coastal producing  regions near the Caspian port of Turkmenbashi.

But on March 30, the Turkmen authorities announced that Berdymukhammedov had instructed the “Turkmengaz” state concern to announce an international tender for design and construction of the 30 million mt/year East-West gas  pipeline with a length of 800-1,000 km.

Such a pipeline would play a vital role in ensuring that any  trans-Caspian pipeline system to Europe would be able to access the giant South Yoloten field, which the UK’s Gaffney Cline declared last September contained a minimum of 4 trillion cubic meters of gas-in-place.

Russian accounts had said the aim of the east-west line was to provide a feeder for the planned Caspian Coastal pipeline, intended to run from the Turkmenbashi area to Russia.

The April 4 statement stressed the importance of a planned conference in Ashgabat over April 23-24 at which Turkmenistan hopes to gain further global support for its proposals to enhance “reliable and stable transit of energy to international markets under the aegis of the UN.” The conference is also expected to serve as a sounding board for companies seeking to take part in the East-West pipeline tender.

To summarize: Turkmenistan has taken a very brash, public, and outspoken position in direct opposition to virtually every Russian/Gazprom position on major gas policy issues, namely control of transportation, pricing, intermediaries, and a “Gas OPEC.”  Russia wants to control the transportation of gas, and ensure that Turkmen gas transits Russia on its way to European markets; Turkmenistan wants direct access to Europe.  Russia wants to control the marketing of gas, via shady intermediaries; Turkmenistan wants to deal with the consumers of its gas directly.  (Side note: another illustration of Russia’s/Gazprom’s peg-the-needle hypocrisy, given its constant demands to have direct access to downstream customers in Europe, and now in the US.)  Turkmenistan is worried that the Russians won’t pay what they’ve agreed.  Russia is seriously shopping the idea of a “supranational” cartel of gas exporters; Turkmenistan flatly opposes this idea so near and dear to Putin’s heart.

They must be fuming in the Kremlin and the White House on the Moskva, especially after

Medvedev said that Moscow and Ashgabat will soon sign new agreements on natural gas production and transportation, RIA Novosti reported. “We studied in detail cooperation in the fuel and energy sector, including progress in the implementation of very important accords, such as the intergovernmental agreement on the Caspian pipeline, and other projects,” Medvedev said after talks in Moscow with Berdymukhammedov.

. . . .

Russian presidential aide  Sergei Prikhodko  told journalists that Energy Minister  Sergei Shmatko  would soon head for Ashgabat to fine tune an agreement on the East-West gas pipeline, to link northeastern Turkmen deposits with the Caspian gas pipeline. He said the Russian and Turkmen leaders would soon meet again to sign the deal.

Given Turkmenistan’s defiance on every major issue, and its recent blunt statements regarding the pipeline explosion (arising from Russia refusing to accept contracted deliveries of gas, according to Turkmenistan), somehow I think that Medvedev can put his pen away.

This raises the question: What accounts for Turkmenistan’s sudden obstreperousness?  Things are so opaque in that part of the world, it’s very hard to say.  My guess is that Gazprom’s/Russia’s acute financial difficulties, and its desperation to get out of contracts to buy gas at high prices, have demonstrated clearly to the Turkmens that they cannot be dependent on Russia, as Russia will screw them at every turn. Moreover, they may sense that Russia/Gazprom are in a weak position right now due to the financial crisis, and so there is now a glittering opportunity to slip out of Moscow’s suffocating grip.  Maybe too the European move in Ukraine gave the Turkmens some indication that the game may be changing.  And, certainly, there must be all sorts of byzantine diplomatic maneuverings going on involving the US, the EU, and China, as well as Russia.

Whatever the reason, Ashgabat’s newfound spunk is very welcome.  I say again: let us hope that Foggy Bottom and Brussels will seize this opportunity, although, I share R’s doubts that they will.

Willem Buiter weighs in the regulatory capture theme:

Governments everywhere are doing the best they can to delay or prevent the lifting of the veil of uncertainty and disinformation that most banks have cast over their battered balance sheets. The   banking establishment and the financial establishment representing the beneficial owners of the institutions exposed to the banks as unsecured creditors – pension funds, insurance companies, other banks, foreign investors including sovereign wealth funds – have captured the key governments, their central banks, their regulators, supervisors and accounting standard setters to a degree never seen before.

I used to believe this state capture took the form of  cognitive capture, rather than  financial capture.   I still believe this to be the case for many, perhaps even most of the policy makers and officials involved, but it is becoming increasingly hard to deny the possibility that the extraordinary reluctance of our governments to force the unsecured creditors (and any remaining non-government shareholders) of the zombie banks to absorb the losses made by these banks, may be due to rather more primal forms of state capture.

Like me, Buiter is concerned about Fed independence and credibility:

sible way from the point of view of medium- and longer-term economic performance, by surrendering central bank independence to the fiscal authorities.

When the Fed lends on a non-recourse basis to the private sector with only a $100 bn Treasury guarantee for a possible $1 trillion dollar Fed exposure (as with the TALF),   when the Fed purchases private securities outright with just a similar 10-cents-on-the-dollar Treasury guarantee or when the Fed is party to an arrangement that transfers tens of billions of dollars to AIG counterparties – money that is likely to be extracted ultimately from the beneficiaries of other public spending programmes or from the tax payer, either through explicit taxes or through the inflation tax – the Fed is acting like an off-balance sheet and off-budget special purpose vehicle of the US Treasury.

When the Chairman of the Fed stands shoulder-to-shoulder or sits side-by-side with the US Treasury Secretary to urge the passing of various budgetary proposals – involving matters both beyond the Fed’s mandate and remit and beyond its competence – the Fed is politicised irretrievably.   It becomes a partisan political player.   This is likely to impair its ability to pursue its monetary policy mandate in the medium and long term.  

The bottom line?  Another SWP mantra:

But with the banking system on its uppers and many key financial markets still disfunctional and out of commission, external financing will be scarce and costly.   This is why sorting out the banks, or rather sorting out the substantive economic activities of new bank lending and funding, that is, sorting out  banking  , must be a top priority and a top claimant on scarce public resources.

Until the authorities are ready to draw a clear line between the  existing banks  in western Europe and the USA, – many or even most of which are surplus to requirements and have become parasitic entities feeding off the tax payer – and the  substantive economic activity  of bank lending to non-financial enterprises and households, there will not be a robust, sustained recovery.

But with the regulators and legislators captured, cognitively, primally, or otherwise, the line is not being drawn.  And hence, “a robust, sustained recovery” is not in the offing.

The compromising of Fed independence and credibility; ballooning, unprecedented fiscal deficits that will be financed either by inflation, or by higher income taxes; and a chronically ill banking system operating under dysfunctional incentives enabled by arguably captive governments is a recipe for prolonged stagnation/stagflation.  The fact that the Fed and Treasury are also fighting against the equilibration of the economy, by propping up sectors of the economy that should contract, only aggravates these problems.  A Lost Decade looms.

If sometimes I seem a little, well, schizo, there’s a reason for that.  On the one hand (or is it personality?), I have deep Hamiltonian sympathies for commerce and industry.  Moreover, I share Hamilton’s view that finance is an essential complement to commercial and manufacturing activities, facilitating as it does the efficient allocation of resources over time and risk across individuals.  On the other hand/personality, I have strong Jacksonian instincts, with a suspicion of big government, and a healthy skepticism (if not Jacksonian hate) for large banks.

The contradiction is more apparent than real, and can be largely eliminated by an appeal to Adam Smith, via Friedman and Stigler.  As these gentlemen often pointed out, Adam Smith was a firm believer in what later came to be called capitalism, but he was deeply hostile to individual capitalists.  Smith was especially critical of large business interests’ exercise of political power to induce the government to extend them favorable privileges or trade protections.  Stigler and his followers subsequently built on Smith’s insight to argue that large, concentrated interests, especially business interests, could effectively “capture” legislators and regulators, thereby securing favorable laws and regulatory decisions.  One can therefore quite consistently be a Hamiltonian supporter of commerce, industry and finance, and a Jacksonian critic of the powers and privileges that commercial, industrial, and financial firms secure through their influence on, and perhaps capture of, the government.

This issue is of direct relevance to the financial crisis, and policy responses thereto.  In a long piece in the Atlantic, former IMF chief economist and current MIT professor Simon Johnson argues “that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises.”  

I am not particularly convinced by Johnson’s argument that capture of the government by large financial institutions led to the adoption of policies that caused the crisis.  I do agree, however, that the baleful political influence of large financial institutions is impeding the resolution of that crisis, and threatens to prolong and deepen it.  

Johnson presents a list of regulatory and legislative developments in the 90s and 00s, and suggests that these various moves to free finance from legal fetters caused the crisis:

From this confluence of campaign finance, personal connections, and ideology there flowed, in just the past decade, a river of deregulatory policies that is, in hindsight, astonishing:

• insistence on free movement of capital across borders;

• the repeal of Depression-era regulations separating commercial and investment banking;

• a congressional ban on the regulation of credit-default swaps;

• major increases in the amount of leverage allowed to investment banks;

• a light (dare I say  invisible?) hand at the Securities and Exchange Commission in its regulatory enforcement;

• an international agreement to allow banks to measure their own riskiness;

• and an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation.

The mood that accompanied these measures in Washington seemed to swing between nonchalance and outright celebration: finance unleashed, it was thought, would continue to propel the economy to greater heights.

I agree that the changes were indeed astonishing.  Some were clearly salutary (e.g., free capital flows).  Most others, (e.g., the repeal of Glass-Steagall, the Commodity Futures Modernization Act that limited–but did not eliminate, as is often asserted–regulation of OTC derivatives) contributed little if anything, in my view, to the coming of the financial crisis or its severity.  One-“an international agreement to allow banks to measure their own riskiness”–is onto something, but not primarily for the reason that Johnson highlights.  The Basel II banking regulations engendered massive efforts to move banking activities, and risk, off balance sheet, and thereby encouraged some pernicious financial engineering driven primarily by regulatory arbitrage/avoidance, rather than legitimate reasons of risk allocation.  A good example of the law of unintended consequences to keep in mind when someone glibly recommends bank capital regulation reform as a magic bullet.

Regardless of whether Johnson or I am correct, that’s water over the damn now.  What is of the moment is where do we go from here.  And in this area, I am largely in agreement with Johnson’s diagnosis that many policymakers are captured by large financial institutions; that the interests of these large financial institutions, their managers and their shareholders, are not aligned with the interests of the rest of us; and that as a result of the conjunction of these two factors, policies to address the financial crisis are dangerously off track and threaten even greater damage.  

Johnson’s analysis agrees with that which I have offered here on SWP, with respect to (a) the great dangers of allowing insolvent or nearly insolvent banks to remain in operation in such a parlous financial condition; (b) the very strong incentive of such banks to continue to operate in hopes that luck or insane gambles will restore them to solvency; and (c) the apparent success of these banks in shaping policies that have given them an unwarranted lease on life, and perpetuated their perverse operational incentives:

This latest plan—which is likely to provide cheap loans to hedge funds and others so that they can buy distressed bank assets at relatively high prices—has been heavily influenced by the financial sector, and Treasury has made no secret of that. As Neel Kashkari, a senior Treasury official under both Henry Paulson and Tim Geithner (and a Goldman alum) told Congress in March, “We had received inbound unsolicited proposals from people in the private sector saying, ‘We have capital on the sidelines; we want to go after [distressed bank] assets.'” And the plan lets them do just that: “By marrying government capital—taxpayer capital—with private-sector capital and providing financing, you can enable those investors to then go after those assets at a price that makes sense for the investors and at a price that makes sense for the banks.” Kashkari didn’t mention anything about what makes sense for the third group involved: the taxpayers.

Even leaving aside fairness to taxpayers, the government’s velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior  must  change. As an unnamed senior bank official  said to  The New York Times  last fall, “It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.” But there’s the rub: the economy can’t recover until the banks are healthy and willing to lend.

The Way Out

Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.

Big banks, it seems, have only gained political strength since the crisis began. And this is not surprising. With the financial system so fragile, the damage that a major bank failure could cause—Lehman was small relative to Citigroup or Bank of America—is much greater than it would be during ordinary times. The banks have been exploiting this fear as they wring favorable deals out of Washington. Bank of America obtained its second bailout package (in January) after warning the government that it might not be able to go through with the acquisition of Merrill Lynch, a prospect that Treasury did not want to consider.

The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary.

In some ways, of course, the government has already taken control of the banking system. It has essentially guaranteed the liabilities of the biggest banks, and it is their only plausible source of capital today. Meanwhile, the Federal Reserve has taken on a major role in providing credit to the economy—the function that the private banking sector is supposed to be performing, but isn’t. Yet there are limits to what the Fed can do on its own; consumers and businesses are still dependent on banks that lack the balance sheets and the incentives to make the loans the economy needs, and the government has no real control over who runs the banks, or over what they do.

At the root of the banks’ problems are the large losses they have undoubtedly taken on their securities and loan portfolios. But they don’t want to recognize the full extent of their losses, because that would likely expose them as insolvent. So they talk down the problem, and ask for handouts that aren’t enough to make them healthy (again, they can’t reveal the size of the handouts that would be necessary for that), but are enough to keep them upright a little longer. This behavior is corrosive: unhealthy banks either don’t lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate—creating a highly destructive vicious cycle.  

The fundamental problem is that insolvent banks face very perverse incentives, and as a result (a) tend to dissipate wealth rather than build it, and (b) banking problems tend to metastasize, with persistent, pernicious effects on the broader economy.  There are a variety of approaches to address this problem.  Johnson advocates nationalization.  Others advocate variants on the good bank-bad bank approach. I’ve added the Humpty-Dumpty twist to the good bank-bad bank alternative.  Although these approaches differ in detail, they all involve some common elements, most notably isolating bad assets, and forcing the restructuring of insolvent institutions (whose insolvency is typically revealed only after the full extent of their bad asset holdings is recognized by stripping out these assets).  This restructuring typically wipes out shareholders, leads to the departure of top management, and can also impose losses on debtholders.  That is, it forces the claimants of insolvent banks, and the holders of their residual control rights, to internalize the costs of insolvency.  Banks shareholders, bondholders, and managers, however, have every incentive to try to externalize those costs.  The gambling to survive option is the most effective way to do that, and that is precisely why recent policy changes, including many features of the Geithner plan, and the recent FASB rule change on accounting for some assets, are so troublesome: these policies enable insolvent banks to extend their lives, and indulge their bad incentives for who knows how much longer, and at what cost.  

As I wrote last week, there are some rumblings from within the administration that suggest that the capture is not complete.  In particular, statements that banks would be forced to write down assets, or to sell them into the Geithner bad loan and bad securities programs, give reason to believe that the administration is aware of the perverse incentives inherent in the black-and-white of the Treasury plan, and intends to take away with regulatory pressure the options that the Treasury blueprint and the new accounting rules have given.  

But that is just a conjecture, and one that gives the administration the benefit of the doubt.  Actions speak louder than words.   Until the banks squeal very loudly that they are being driven to the wall by Treasury or FDIC dictates to sell bad assets, thereby revealing to all the extent of their financial position (insolvent or no?), I will continue to believe, along with Simon Johnson, in the literal words of the Treasury plan.  Those words give tremendous discretion to banks with bad incentives.  That screams capture, and bodes ill for the future.

And even if the Treasury and Fed and FDIC are truly being Machiavellian, taking away through left-handed pressure the optionality that Treasury extended with the right hand of the PPIPs program, it would be much more comforting if it acted in a straight-forward manner.  It would provide a stronger signal that they are in fact not prisoners of the bad banks.  And what’s more, due to their political power and influence, it is quite possible that they will be able to deflect, if not defeat altogether, pressure that the government attempts to bring to bear.  

This should give pause to those that view “more regulation” as a mantra that will fix all of our problems.  That is a dreamy vision of regulation, that works in Nirvana, but not here on earth.  On earth, individuals and firms with large sums at stake and superior information almost invariably shape regulation to their benefit.  Both conditions hold in banking today, and given the complexity of modern financial institutions and the products they trade, the informational advantages of the banks over legislators, let alone the GS 12s, 13s, and 14s expected to bring them to heel, are immense.  It is wildly optimistic to expect that the normal operations of politics and regulation will lead to an outcome that is not far too beneficial for banks, their shareholders, their bondholders, and their executives.

That is, the problem is an economic one, but its solution is at heart a political one.

And maybe that brings us back to Andrew Jackson.  Jackson exerted enormous political power to undermine the Second Bank of the United States, an institution that had been associated with (believe it or not) extremely lax credit policies that fed a speculative land boom and endemic corruption.  The deeply libertarian Jackson believed that the BUS was a threat to both the economy, and American political liberty.  He prevailed in a titanic political struggle against Nicholas Biddle (the bank’s president), Henry Clay, and Daniel Webster.  

Now, Jackson’s banking policy as a hole was hardly admirable, but his actions do indicate that capture is not inevitable.  But there is room for considerable doubt whether anything remotely Jacksonian is likely to come out of Washington today.  Which means that the regulatory capture that Simon Johnson laments may be with us for a long time, with baleful consequences.

I’ve mentioned several times that I have invested in Treasury Inflation Protected Securities, or TIPS, due to my serious concern that inflation is a major threat given the Fed’s vast expansion of base money.*  That idea is apparently going mainstream, with many big “real money” managers taking the same position:

At  BlackRock Inc., Vanguard Group Inc.,  Pacific Investment Management Co.and Pictet & Cie Banquiers, concerns are growing that policy makers will struggle to control inflation once economies start to recover. The Federal Reserve, Bank of England and European Central Bank have increased money supply by an average 9.2 percent in the past year, or the equivalent of $2 trillion, to $24 trillion, according to the broadest measure each uses.

. . . .

“Inflation worldwide is going to surge in the years to come,” said  Mickael Benhaim, who manages about $32 billion as head of global bonds at  Pictet  in Geneva. “On the supply side, issuance of the securities as a ratio of overall government debt is sharply declining,” which “makes linkers look very attractive,” he said.

Benhaim says there’s a shortage of inflation-linked debt in the U.K. too. There are about 180 billion pounds ($266 billion) of index-linked gilts outstanding, or 23 percent of the total debt, down from 30 percent a year ago, U.K. Debt Management Office data show.

In the euro region, where the ECB targets an inflation rate of just under 2 percent, the market totals about 250 billion euros ($336 billion), or 7 percent of all outstanding debt, down from 7.2 percent a year ago.

TIPS Cheapest

BlackRock‘s Weinstein said TIPS are the cheapest inflation- linked bonds. Notes maturing in one, two and three years have the smallest breakeven rates outside Japan, where deflation expectations persist through 2010’s first quarter, according to the median response in a Bloomberg survey of 16 economists.

“On a  relative value  basis, the U.S. inflation market is the one I would rather  own,” Weinstein said. “If I could sell U.K. breakevens and European breakevens and buy U.S. breakevens, I would.”

Of course, not everybody has a clue:

“Inflation is driven historically by wages, and clearly if you have the unemployment rate rising, it begs the question where will you get inflation from,” said  Chris Lupoli, executive director for global inflation-linked strategy at UBS AG in London. “We’re projecting that there will be a global healing but that the recovery will be anemic.”

Uhm, Chris, the Phillips Curve died like, you know, 30 years ago.  Heard of stagflation?  It is possible to have both high unemployment and high inflation.  

I have repeatedly heard it said that the Fed has the tools to combat inflation when money demand/velocity picks back up again.  It can sell the securities it has bought to sop up the additional money it injected into the economy when it purchased them.

I have no doubt the Fed has the tools.  The question is: Does it have the will to use them?

I have very, very, serious doubts that its promises to fight inflation are credible.  Would the Fed really sharply increase interest rates when the economy is just recovering from a deep recession/depression, running the risk of aborting a resurgence of growth?  Is it likely that the Fed will sell large quantities of mortgage backed securities, potentially driving up mortgage rates and reducing housing prices, thereby risking another housing crash?  Will the Fed be able to resist the political pressure to monetize Obama’s huge deficits?  Moreover, the Fed’s involvement in the various bailout plans, its close cooperation with Treasury, and the rampant populism on the Hill, all raise the risk that the Fed’s independence has been compromised.  Given these factors, the risk of an unprecedented inflationary spurt is appreciable.

Or, to put it differently, in my view the only way we are likely to avoid a serious uptick in inflation is if the economy remains mired in near depression conditions.  I estimate that the odds of a non-inflationary recovery are very low.

I am not alone.  James Hamilton said it better than I could:

A second concern I have with the new Fed balance sheet is that it has seriously compromised the independence of the central bank. To my knowledge, every hyperinflation in history has had two key ingredients: (1) budget deficits that could not be resolved politically, and (2) a central bank that assumed the obligations that the fiscal authority could not.

In the U.S. today, there is little question in my mind that repaying the projected deficits with tax increases or spending cuts will be extremely difficult politically. Each additional trillion dollars would roughly require  doubling the personal income tax rate  on all Americans for one year, something I cannot see the political process delivering. There is enormous pressure in the current situation to defer solutions and look for temporary fixes with off-balance-sheet measures. The reason that the Fed is sought as a partner for the Treasury in all these new actions is because the Fed is perceived to have deeper pockets than the Treasury. This is not a situation that a self-respecting central bank should let itself get into.

My third concern is that the new Fed balance sheet has handicapped the Fed’s ability to fulfill its primary mission, which I see as promoting a stable and predictable low rate of inflation. Which of the Fed’s new assets would it sell off when it needs to  absorb back in  the huge volume of reserves it has recently created? The Fed’s hoped-for scenario is that the reserves won’t need to be called back in until the situation has stabilized and the facilities are no longer needed. But I am concerned instead about the possibility of a dramatic shift in the perceptions of foreign lenders, in which case inflationary pressures could emerge in a situation that is far more chaotic than the one we currently face.

I recommend instead that the Fed should be buying Treasury Inflation-Protected Securities in the current situation.  Tim Iacono  says that’s like the Mafia buying “protection” from itself. But my point is that TIPS represent an asset that would gain in value at a time the Fed needs to sell them, meaning that the logistical ability of the Fed to drain reserves quickly in such circumstances is without question.

What we need in the current situation is a central bank that is a bulwark of stability. A profound lack of confidence in the U.S. government itself would make our current problems look like a walk in the park. If the Fed had the means and the credibility to deliver a stable and low inflation rate, I believe that would go a long way to solving our current problems.

But it’s not clear the Fed has either the means or the credibility.

Not clear at all.

The potential for an inflationary outbreak is not bad news for everybody, though.  It is good for those long commodities, especially oil.  Indeed, the best hope for Russia, Iran, Venezuela, etc., is substantial dollar inflation.  An incredible Fed could be Putin’s best friend.  

* I do not offer investment advice.  Period.  I only mention this to indicate that I am putting my money where my mouth is.  

FT Alphaville discusses the FSAB’s decision to relax mark-to-market requirements for banks for assets for which the market is inactive, or for which prices are distorted by numerous fire-sales, and the implications of this for bank stocks.  I think this is a bad idea, but being pressed for time, for now I will merely repeat the comment I left on the FT post:

The reason that accounting rules should influence one’s decision on whether to buy banks is different from those you mention in this post. The value of bank stocks right now, especially the dodgy ones, derives from the government put (either formally, through deposit insurance, or informally through the too-big-to-fail bailout possibility). The value of this put is greater, the longer banks have the opportunity to survive, and potentially gamble their way out of insolvency, or catch a break from an unexpected upturn in the economy to save them from receivership. Obfuscating the value of assets, and giving banks more discretion over their valuation through choice of accounting treatment, extends the life of that option, and makes it more valuable.  

So, to the extent you believe that accounting rules or other mechanisms will permit insolvent banks to extend their lives, and exploit volatility (and indeed, increase volatility) and the government put, then yes, it may be a time to buy banks. Sadly, the banks’ shareholders’ gain is not a social gain, as it is achieved at the expense of those underwriting the put. Namely, me and other American taxpayers.  

We saw this before, in the S&L crisis, when in the mid-80s “regulatory capital” and other accounting dodges permitted (a) insolvent institutions to survive, and (b) Congress to avoid appropriating the money to address the problem when it would have been cheap to do so. We all know how well THAT turned out. A manageable, relatively inexpensive problem metastized into a barely manageable, very expensive one. But, those who cannot remember the past etc., etc.

Willem Buiter weighed in a few hours later with similar remarks:

Under FAS 157, the FASB’s standard on fair-value measurements, holders of financial assets recorded at fair-value must state what these values are based on. Three levels of information or assumptions are distinguished, corresponding to   how “publicly observable” the information is. In level 1, the value of an asset or liability stems from a quoted price in an active market. In level 2, it is based on “observable market data” other than a quoted market price. In level 3, which often applies to asset valuations in illiquid markets or in “distressed” sales (or “fire sales”), fair value can be determined only by inputs that cannot be observed or verified objectively.   Typically this means prices based on internal models or management guesses.

Basically, the new guidance allows banks to shift a whole load of toxic and impaired securities from level 2 to level 3.   Up till now, a frequent source of level 2 information were prices achieved by competitors’ asset sales to help determine the fair-market value of similar securities they hold on their own books. Banks are now allowed to ignore prices achieved in competitors’   asset sales when these transactions aren’t “orderly”.   This includes transactions in which the seller is near bankruptcy or needed to sell the asset to comply with regulatory requirements.   This is vague and broad enough to drive a coach and horses through fair-value accounting for most imperfectly liquid assets.

Leaving the valuation of illiquid securities to managerial discretion will lead to systematic and systemic overvaluation.   Banks with significant amounts of toxic assets and plain bad assets on their balance sheet have lied, lie and continue to lie about what they have on their balance sheets.   This has now been made easier.   No wonder bank stocks rose and bank credit default swap rates declined.   Reported asset values will be boosted.

Analysts estimate that, now that banks can mark toxic assets using their own models (which are private information) rather than what they would fetch on the open market, quarterly profits at some banks could be boosted by up to 20 per cent.

. . . .

The official excuse for this egregious pandering to the interests of zombie bank managers and unsecured creditors is that mark-to-market (or fair value) accounting is to blame for exacerbating banks’ capital problems and causes exacerbation of pro-cyclical and potentially systemically destabilising   detrimental feedback loops between lack of market liquidity, distress asset sales, mark-to-market, margin calls, falling asset prices and lack of funding liquidity.

That argument makes no sense.   It is clearly desirable that regulators and supervisors exercise regulator/supervisory forbearance as regards the implications of mark-to-market for regulatory capital requirements and for any other regulatory requirements when asset markets are distressed and illiquid.   They should do the same when asset markets are perfectly liquid but subject to speculative bubbles.

But  given  micro-prudential regulatory forbearance as regards mark-to-maket capital losses incurred on illiquid securities, and  given  sensible macro-prudential responses by regulators, monetary and fiscal authorities when securities markets are illiquid, there is no earthly reason for deliberately lowering the informational content and quality of published corporate accounts.   This impairment of the informational content of the corporate accounts will be the inevitable consequence of replacing valuation using market prices (even illiquid market prices) with the judgment of the deeply conflicted managers of these corporations. Investors will be worse off.   Corporate governance will suffer.   Accountability of corporate executives and boards will diminish.   And, because mark-to-myth is likely to prevent necessary corrective measures from being taken, or at least to delay them, the FASB’s encouragement of marking-to-myth is likely to increase future financial instability.

Conclusion

It really is wonderful how the US political and regulatory establishment is riding out in support of its wonky banks.   First, the Treasury Secretary Timothy Geithner proposes a toxic and bad assets purchase scheme (the PPIP or Public-Private Investment Program) which subsidizes the private parties in the public-private partnerships   bidding for the toxic assets by leveraging the private and public equity involved in the bids through non-recourse loans or guarantees.   This permits – indeed encourages – private bidders for toxic assets to make bids far in excess of their estimates of the fair value of these assets.   Their rents can then be split between the private bidders for the assets and the banks selling them.

Second, in case even this isn’t good enough, banks that would rather not sell these toxic or bad assets, even at these inflated prices, can avoid pressure (from the regulators or from shareholders) to sell by marking-to-model (that is, marking-to myth) the assets rather than marking to market.   This gives the management of the bank more time to ‘gamble for resurrection’ at the expense of the shareholders and other stakeholders, including the tax payers.   Most importantly, banks with large amounts of undeclared crud on their balance sheets will act like zombie banks, engaging in little new lending or new investment in the real economy.   While their managers sit, wait and pray for a miracle, intermediation between households and non-financial enterprises continues to suffer.

The G20 have made many pious statements about the need to recognise the losses that have been incurred, on and off the balance sheets of banks and shadow banks, and to ensure that the dead hand of the overhang of past losses does not act as a tax on and deterrent to new lending and borrowing by banks.   Yet the primus inter pares in the G20, the USA, decides to give its banks another large fig leaf behind which to hide their losses and gamble for resurrection.   This continues and prolongs the zombification of most Wall Street banks.

The FASB, like the rest of the American regulatory and standards-setting establishment, appears to have been captured lock stock and barrel by the vested interests of the large Wall Street zombie banks (management, shareholders and unsecured creditors).   This may well have been another example of cognitive regulatory capture, like that which has afflicted the SEC and the Fed.

No doubt the IASB will wimp under also, and promulgate a new ukase permitting European banks also to substitute managerial judgment/wishful thinking for market valuation. Our accounting standard setters are making terrible and very costly choices.   Paraphrasing Churchill: mark-to-market accounting is the worst accounting principle in the world, except for the others.

Buiter’s capture point is an excellent one, and one that I have been planning to write on for awhile.  Maybe this weekend will provide the time to do it.   I note merely in passing, that the PPIPs program is also severely tilted in favor of big, politically influential real money managers, e.g., BlackRock and PIMCO.  I wonder how that happened.

In related news, Bloomberg reports that Federal regulators are considering forcing major banks to write down assets by $1 trillion:

U.S. regulators may force Bank of America Corp.,  Citigroup Inc.and at least a dozen of the nation’s biggest financial institutions to write down as much as $1 trillion in loans, twice what they’ve already recorded, based on Federal Deposit Insurance Corp. auction data compiled by Bloomberg.

Banks failing Federal Reserve evaluations of loans this month may be ordered to make sales worth as little as 32 cents on the dollar, according to FDIC data. That would be less than half of the 84 cents on the dollar the Treasury Department suggested was a possible purchase price. Some of the bank- insurance agency’s auctions brought 0.02 cent on the dollar.

Regulators are apparently aware that the Achilles Heel of the Geithner plan is the optionality it extends to banks:

“If there’s an issue with the program, it’s going to be trying to get banks to sell assets,” FDIC Chairman  Sheila Bair  said in a speech the same day at the Isenberg School of Management of the University of Massachusetts in Amherst.

“If I have concern, it’s the pricing may not be where seller and buyer are willing to meet,” she said.

Any standoff between investors and banks over loan prices may scuttle Geithner’s plan to segregate non-performing assets and restart lending, said  Bob Eisenbeis, chief monetary economist with Vineland, New Jersey-based Cumberland Advisors and a former Atlanta Federal Reserve Bank research director.

‘Really Bad Stuff’

“It’s hard to believe that the really bad stuff that’s causing all the problems are going to be offered for sale,” Eisenbeis said. “The institutions won’t want to sell them if they get a true price, because their capital would take too much of a hit.”

This is an advance, and one wonders whether Bair, Geithner and others knew it all along, and planned a pincer movement–establishing PPIPs as a mechanism for buying these assets, and then hitting the other flank by using regulatory pressure to force banks to sell.  

But why the indirection?  Is this politically driven?  That is, was this strategy of the “indirect approach” (to borrow a phrase from military writer Liddell Hart) chosen over the “direct approach” (i.e., good bank-bad bank in some variant) because the judgment was made that the latter would crumble in the face of fierce bank resistance?  Is this driven by an assessment of regulatory capabilities, i.e., a consideration of what regulatory weapons the FDIC has at its disposal?  Is it primarily driven by a recognition that Congress would never fund the direct approach, so stealth bailouts are required, and regulatory pressures are necessary to make the purportedly “voluntary” Geithner plan work?  

I don’t know the answers to these questions.  I would prefer the direct, transparent approach.  The indirect, apparently disconnected approach could be attributed to canny strategizing, but it could also indicate intellectual confusion, ad hoc decision making, extemporization, and the dysfunctional consequences of a dysfunctional Congress.  

I would also note that there is incredible tension and inherent contradictions in much of the policymaking.  The FASB action completely undercuts the Geithner plan–as a standalone initiative.  If, in fact, the Geithner plan is part of a pincer strategy in which the government will force banks to participate by forcing writedowns, the FASB action raises the level of government force required to achieve that end.  

My main concern about these indirect, opaque plans to deal with banks is related to a point I made in my FT comment.  Namely, we have been here before, in the S&L mess in the 80s.  Congressional malfeasance then made a bad problem into a horrific one.  Congressional failure to grasp the nettle, and fund a reasonable cleanup of the S&Ls led regulators to resort to all sorts of indirect “fixes” that only allowed the problems to metastasize.  

The most charitable interpretation of the administration’s actions is that it recognizes that the current Congress is likely to commit malfeasance on even a grander scale, and hence feels compelled to disguise bailouts by making vast commitments, unfunded at the present (most importantly, the commitments inherent in non-recourse lending), but which will effectively force Congress to provide funding in the future when the bills come due.  

I would prefer a more direct, honest, and transparent approach.  It would provide confidence that the true problem is understood and is being addressed, whereas the present course leaves considerable room for doubt.  But, being charitable to the administration requires one to believe that even it views Congress as incorrigible, irredeemably unreliable, and counterproductive.  That is perhaps the most sobering, no, disturbing, possibility of all.  

Several months ago, during a raging debate on the consequences of the world economic crisis for Russia, a commentator whom I’ll call BFC excoriated me for my pessimism.  He pointedly asked if things were so bad, why were reputable organizations, such as the World Bank, making much sunnier (though hardly great) forecasts for the 2009-2010 Russian economy.  

All good things come to those that wait, B.  The World Bank has released its Russian Economic Report 18.  (Links to report and a powerpoint presentation are to the right on the linked page.  You can read the entire report, but its main results are summarized in the ppt presentation.)

It’s full of I-told-you-so material for SWP.  Key sentences:

With a much worse global financial outlook and oil prices in the USD 45 a barrel range, Russia’s economy is likely to  contract by 4.5 percent in 2009, with further downside risks. This represents a major downward adjustment from our  forecast in November 2008, which saw growth at 3 percent, based on growth of the world economy and oil prices around  USD 75 a barrel. (Emphasis added.)

In other words, the WB was unduly optimistic last year, when the debate was raging here on SWP.  

The report makes frightening reading (not that there is a single economy out there for which 2009-2010 looks good).  I would direct attention to a chart on p. 12 of the World Bank report, in Box 2.1, which plots growth rate deceleration (vertical axis) against fiscal stimulus (horizontal axis).  Look at the point way down at the bottom.  The one labeled “Russia.”  It means that the WB forecasts that the growth rate for Russia will decelerate more than for any other G-20 economy.  I repeat.  The growth rate for Russia will decelerate more than for any other G-20 economy.  In other words, by one measure, the WB validates my assertion, contested so vigorously by BFC and a couple of others, that the world crisis would hit Russia harder than the US and most other industrialized economies.  

This measure is related to one I’ve mentioned in a couple of recent posts, namely the growth gap: the difference between growth potential and actual performance.  The combination of the facts that (a) Russia was growing fairly rapidly 2006-1H 2008, and (b) has contracted more than other G-20 economies, means that (c) the growth gap in Russia is very large indeed.  This is reflected in the rapid deceleration in Russian growth.

Another particularly interesting and revealing chart is Figure 1.1.  Compare the performance of Russia not so much to the developed economies, but its developing peers.  Note how much Russia has underperformed these nations in the crisis.  

The rest of the report is chock full of interesting details.  I’ll call out a couple.  First, investment in Russia (never high when compared to other rapidly growing economies, e.g., the “Asian Tigers”) has plummeted, down in the fourth quarter by 1.1 percent, down in the first two months of the year by almost 15 percent.T  This bodes ill for long term growth.  Second, consumption has also declined after dramatic growth in previous years.  Third, construction is down 18 percent.  Fourth, unemployment forecast to be 12 percent. Fifth, disposable income down sharply.  I could go on.

The adjectives in the report are also quite illuminating.  Phrases like “rapidly decelerating” and “collapsing domestic demand” are sprinkled throughout.  

The report pays special emphasis to how the crisis has seriously eroded the laudable progress made against poverty in the last several years.  The poverty, unemployment, disposable income, and consumption numbers all point to potential sources of popular discontent.  

Furthermore, the report repeatedly emphasizes that Russia’s policymakers face serious constraints that severely limit their choices.  Sound familiar?

And if you think the World Bank is gloomy, it is a starry-eyed optimist compared to the OECD.  The OECD’s report on the Russian economy forecasts a 5.6 percent decline of GDP in 2009, as compared to the World Bank forecast of -4.5 percent.  The OECD report notes that the Russian recovery is highly dependent on exogenous factors, especially the price of oil (another point BFC disputed vigorously).  

So, BFC, you asked for it . . . you got it.  

It should be noted that big organizations like WB, IMF, and OECD are frequently lagging indicators.  Prudence, and the fact that they are political bodies, dictate that they be very cautious in their assessments.  In contrast, mere bloggers can be more aggressive and opinionated.    

Oh, I have to mention just one other thing before closing this post.  It speaks volumes: “Russia Seeks to Carve Out Role in Crisis-Hit World Economy“:

“I think in general they see this crisis as a way to show the world that they have some answers and they’ve moved on,” said Tim Ash, head of CEEMEA research at RBS in London.

“It is a great opportunity for them to re-jig the global financial architecture and put themselves in a central place.”

Arguably Russia’s closest allies are the other BRIC nations, emerging market powerhouses Brazil, China and India. All have sizeable foreign currency reserves and are vulnerable to the global slowdown as they rely on exports.

This month the BRICs released their first communique at a G20 finance ministers’ meeting and joined the Financial Stability Forum, signaling a growing world role.

The communique reflected some of Russia’s campaigns, calling for “major reserve issuing economies…to ensure that the macroeconomic policy is more balanced” and for a reshuffle of country representation at the International Monetary Fund (IMF).

Russia followed that up with its own proposals for Thursday’s meeting of G20 leaders. Its suggestion to replace the dollar with a new international reserve currency quickly found support from China and sparked international debate.

Now, the first quote is the view of a certain Mr. Tim Ash, but if it is at all a reflection of Russian official thinking–and there is independent information that would tend to support that view–then they are delusional.  They have answers?  They have a Plan to Save the World?  

As the World Bank and OECD note, they have huge problems at home, and limited policy tools to deal with them.  They have more than enough on their hands at home even to think about saving the world.  Their reserves, shrunken as they are, are doubtfully sufficient to address their own pressing issues, let alone provide a meaningful prop to the world economy.  Their policy ideas are primarily aimed at weakening the US, rather than contributing to a meaningful improvement in the world financial system.  (When I read their proposals, or hear Lavrov or Medvedev speak of them, I am reminded of the punchline of the old joke about the Russian given a wish by a genie: “I wish that my neighbor’s cow dies.”)    

The entire world is hurting economically.  I stand by my previous forecast that due to the very structure of its economy and institutions, Russia is hurting, and continue to hurt, worse than most others.  The World Bank and OECD are coming around to that view.

In It’s a Wonderful Life, facing financial ruin and scandal, banker George Bailey attempts suicide.  Rescued by his guardian angel Clarence, a still bitter George laments that he wishes he had never been born.  Clarence shows him that the world would have been a poorer place without him, and George regains his will to live.

Certainly the 21st century remake of the Frank Capra/Jimmy Stewart classic couldn’t feature an executive from AIG’s Financial Products unit, right?  More likely, in the 2009 version a crowd gathering at the bridge over an icy New England river outside of Greenwich would be shouting “Jump!” to the distraught exec standing on the rail–if they didn’t rush to throw him in bodily.  The modern-day Clarence would rescue him just to torment him with a demonstration that yes, the world WOULD have been better without him because then there would have been no financial crisis.

But not so fast.  It’s not so clear by any means that this morality play would be reality-based.  It is in fact quite possible that the world would have been a worse place without AIG; that the financial crisis would have been more severe; and that taxpayer bailouts would have been bigger.

AIG has been at the center of many of the debates over the financial crisis, and possible regulatory responses to it. In particular, the company’s fate has been used to justify the creation of a clearinghouse for credit derivatives, and indeed for all OTC derivatives. It is often argued that had there been a clearinghouse, the AIG debacle wouldn’t have happened. What’s more, it is often asserted that by taking on so much real estate price risk by writing protection on collateralized debt obligations backed up by subprime mortgage debt, that AIG triggered the financial crisis when these positions went south, requiring a massive taxpayer bailout.

In my view, both views are wrong.  Although AIG’s decisions were certainly a disaster for its shareholders, the systemic implications of AIG’s original plunge into CDOs, and the subsequent collapse of this strategy are vastly overstated.  AIG’s collapse was a symptom of the underlying systemic problem, not its cause.  The cause was the real estate bubble and the huge pyramid of structured finance built on top of it.  Although AIG arguably contributed to the size of that pyramid, its shareholders absorbed a good deal of the blow resulting from its collapse.  Without AIG, the major banks and investment banks–the Citis, the Goldmans, and the other firms that traded with AIG–would have suffered even worse losses, and required an even larger bailout.  A systemic event would have occurred if AIG didn’t exist, and that crisis likely would have been more severe.

So, maybe AIG isn’t George Bailey.  But it isn’t the financial devil incarnate either.  The obsessive focus on the company, and on legislative and regulatory remedies to prevent the recurrence of another AIG, are distracting attention from the true sources of the financial crisis, and the policy lessons to be drawn from it.

I’ll first focus on the clearing issue, because (a) Treasury Secretary Tim Geithner recommended the mandatory formation of a clearinghouse as a means for preventing future financial crises, and (b) it is a focus of my research interest.  A close examination of clearing also helps to bring into sharp focus the key forces driving the financial crisis, and AIG’s role in it.

This view that clearing could have prevented the AIG problem, and the necessity of spending amounts of huge taxpayer dollars in a bailout, is based on an incomplete understanding of how clearing actually works. A more complete analysis demonstrates that it is unlikely that clearing would have made a blow up less likely, and it would almost certainly have made things worse by concentrating the risk on fewer systemically important banks.

This conclusion is obviously completely contrary to the conventional wisdom, but I think it is the right one once one takes into account the way derivatives markets and clearing actually work. The situation is a complex one, so it takes a rather involved argument to make the point. I apologize in advance, but bear with me. Hopefully it will be worth it.

It is helpful to break the argument into three parts. The first part assumes that the adoption of clearing would not have affected the positions that AIG assumed. The second part considers whether clearing would have induced AIG to take on smaller positions. The third part examines whether things would have been all that different had AIG in fact reduced its positions in response to the adoption of clearing.

The conclusions, in brief:

• Holding AIG’s positions constant, clearing would have not substantially affected the allocation of losses among its trading parties, and if these losses required a bailout without a clearinghouse, they would have required them with a clearinghouse;
• if anything, the losses from an AIG default would have been concentrated at fewer banks (the members of the clearinghouse, a subset of AIG’s counterparties);
• although clearing would have presumably raised the costs that AIG incurred to hold positions (due to margining), it is very plausible that these costs would not have been so large to have induced AIG to reduce substantially its positions, given its estimation of how profitable they were;
• even if AIG had reduced its positions, since its counterparties were trading to hedge their exposures to structured products, these counterparties would have incurred larger losses on these positions, losses that would have likely .have required a government bailout of these firms; and
• only if clearing had led AIG to scale back its trading, AND if such a scaling back of AIG’s trading had led to a substantial reduction in the issuance and holding of the securities that AIG’s counterparties were hedging through the insurer, AND if this in turn had led to a substantial decline in the amount of subprime lending, would clearing have had a material effect on the financial crisis.

That is, any effect of clearing on the financial crisis insofar as it relates to AIG would have been extremely indirect. Moreover, it is very difficult to evaluate just how extensive these indirect effects might have been.  Indeed, in my view, there were so many powerful economic forces contributing to the real estate bubble and the explosion in structured finance, that it is likely that both would have assumed almost the same proportions, and imploded with the same effects even if AIG had never been born.

Several themes recur through the analysis, and given that it can become complicated at times, it is worthwhile highlighting those at the outset.

The first theme is that there is a very limited cast of characters here: AIG and the major banks that AIG traded with. The major banks bore AIG’s counterparty risk as OTC counterparties. But crucially, these same banks would almost certainly have been the members of a clearinghouse, and hence would have borne the counterparty risk even in a cleared market! Indeed, due to the way clearing works, these banks might have had a greater exposure to AIG counterparty risk in a cleared market than in a bilateral one.

The second theme is that these very same banks were trading with AIG to hedge the risk on various products (e.g., CDOs) that they carried on their balance sheets. Had AIG not been around, or had traded less, they would have suffered losses on these products. In the event, AIG bore the losses. That is, AIG’s equity absorbed losses that otherwise would have fallen on the equity of these very same banks. They would have been in even worse shape than they are now! So, if it was necessary to bail out AIG to ensure these banks didn’t fail, without AIG it would have been necessary to have bailed out the banks directly, and paid more money to do it.

Only if the absence of an AIG to absorb risk had induced the banks not to buy these risky securities in the first place, and this led to a reduced scale of issuance of these securities, would things have played out differently in a good way. That outcome is highly conjectural. Therefore, any assertion that clearing, or any other regulatory or institutional change that constrained AIG’s risk taking is equally conjectural.

Let’s now get to the details of the argument, and compare how counterparty risk is allocated in a clearinghouse and a bilateral market. This comparison has immediate implications for the effects clearing would have had on the allocation of this risk, and the ultimate effects of the real estate collapse on the health of large financial institutions.

A clearinghouse (central counterparty, “CCP”) has member firms. These members are usually large financial institutions. A credit derivatives clearinghouse would almost certainly be dominated by large banks. The clearinghouse only has a relationship with its members. Customers do not have a direct relationship with the clearinghouse. They must trade through members.

I’ll assume that AIG would have not been a member of the clearinghouse (a similar argument would obtain if it were.) Therefore, it would have traded through member firms—major banks. AIG would have had accounts at one or more clearing members. Given its size, it would likely have had accounts at several members.

The important thing to recognize is that these members are the first line of defense against a default by a customer. That is, if a customer defaults, the firm(s) it clears through must make good the loss. Only if these default losses in turn force one of the clearing members into default do losses get passed to the clearinghouse. But then, the losses are shared among the other members of the clearinghouse. If (a) the capital of the clearinghouse, including any guaranty fund, cannot cover the default losses, and (b) the obligations of solvent clearing members to cover any remaining loss are smaller than that loss, then (c) those with positions on the opposite side of the market to the defaulter would absorb losses.

So, who bears the losses of a default?: (a) the other members of the clearinghouse, and (b) perhaps other customers (if the default loss is so large as to break the clearinghouse).

To get an idea of who the members of a clearinghouse likely would have been, let’s look at the current list of members of ICE Trust, the first CDS clearinghouse to get up and running:

• Bank of America Corp.
• Barclays Capital
• Citigroup
• Credit Suisse
• Deutsche Bank
• Goldman Sachs
• JP Morgan Chase & Co.
• Merrill Lynch & Co.
• Morgan Stanley
• UBS

Now let’s look at the list of the major counterparties of AIG who received money from the bailout:

• Société Générale (France)
• Goldman Sachs
• Merrill Lynch International
• Deutsche Bank
• Calyon, Crédit Agricole (France)
• UBS
• Barclays
• Coral Purchasing, DZ Bank
• Bank of Montreal
• Rabobank
• Royal Bank of Scotland
• Bank of America
• Wachovia
• HSBC
• Barclays Global Investors
• Here’s a link that breaks out the amount owed to each counterparty.  The original document has disappeared from an AIG website.

Note that there is a lot of overlap there. Moreover, if AIG’s default had been so huge as to break the clearinghouse, the very same counterparties in the list would have borne some loss.

That is, given AIG’s positions, clearing would have had NO EFFECT on the size of AIG’s loss. Moreover, it would have had little effect on who bore those risks. Indeed, it would have almost certainly INCREASED the loss borne by the banks that would have been members of the clearinghouse.

Why? Well, exactly because the overlap between counterparties and CCP members is incomplete.  The counterparty firms receiving bailouts  not in the list of CCP members (plus other firms that traded with AIG but which didn’t receive bailouts, e.g., some hedge funds) had taken positions on the opposite side of the market from AIG. These firms would have made money when AIG lost money. In a cleared market, in the event of an AIG default, the clearing firms would have been obligated to pay these firms what AIG owed them, but could not pay. In contrast, in a bilateral market, the banks in the list would have had no such obligation. Thus, the clearing member banks’ share of the loss arising from an AIG default would have been larger with clearing, than they were in a bilateral market.

So, if AIG’s failure necessitated a bailout to save these banks without clearing, its failure would have required a bigger bailout of the CCP member banks with clearing!  That is, Goldman, Citi, Merrill, BofA, etc., would have needed more support.  Moreover, the total would have likely exceeded the amount actually distributed to all the counterparties, because (a) presumably not all of AIG’s counterparties received bailout money, just those deemed systemically important, and (b) in a cleared market, the clearing members would be on the hook to all those owed money, not just those favored by the government.

In a nutshell: given the size of AIG’s positions, the total loss from its would be the same with clearing or without.  All clearing would have done is affected the allocation of those losses among counterparties.  The most likely outcome is that clearing would have concentrated the loss on a smaller number of systemically important banks–the very same banks that the government decided could not go under, and who had to be bailed out by funneling money through AIG.

This means that a necessary condition for clearing to have made things better is that it would have induced AIG to hold smaller positions. This raises two questions: (a) is it plausible that this would have happened?; and (b) even if clearing had induced AIG to hold smaller positions, would it really have made things better (i.e., would smaller positions have been sufficient to ensure that the financial crisis would have been less severe)? I believe the answers to both questions are “no!” At the very least, they are not obviously “yes.”

First consider whether clearing would have induced AIG to hold smaller positions.

Due to its high credit rating, AIG’s counterparties did not demand that it post collateral when it created its positions (though they did include “credit triggers” in the deals allowing them to demand collateral in the event of an AIG downgrade).  A CCP would have established minimum initial collateral levels for customers, and implemented a system of margin calls based on changes in mark-to-market values of AIG’s positions as a customer.

Margins/collateral are costly.  They typically must be posted in cash or near-cash instruments, thereby requiring firms to hold more of their assets in these low yielding instruments than they would prefer.  Thus, it is possible that by increasing the amount of collateral that AIG would have had to post that a CCP would have raised the costs AIG incurred to hold its positions, thereby inducing it to cut back on them.

But I doubt they would have cut back that much.  AIG loaded the boat on the CDSs on CDOs because it believed that these instruments would be very profitable.  Yes, higher collateral would have cut into those margins, but given how big AIG’s FP unit thought the margins were, it is unlikely that they would have cut back all that much.

Moreover, based on its modeling, AIG perceived that the risk on these positions was extremely low, in large part due to its belief (based on analysis of mountains of data by Gary Gorton) that the correlations between the risks of the assets underlying the CDOs were very low.  It is almost certainly the case that a CCP, given information available at the time, and no doubt influenced by AIG’s efforts to press its views and research, would have arrived at the exact same conclusion.  The rating agencies did.  Monoline insurers did.  Why would a clearinghouse been have been any different?

If as I surmise the CCP had determined that the risk of these instruments was low, it would have set low initial margins.  Again, given AIG’s perception of the risk-reward profile of these deals, it is highly likely that it would have been willing to pay these margins, and continue to load the boat.  Perhaps not all the way to the gunwales as it did, but put it pretty deep in the water nonetheless.

Furthermore, it should be noted that by allowing it to trade without collateral, AIG’s counterparties effectively extended credit to the firm. They presumably would have been more than willing to extend credit to AIG as clearing members too, thereby allowing the firm to borrow to meet its margin requirements.  Now this borrowing would have been on balance sheet, and could have constrained the firm’s financing in other ways, whereas the implicit credit in the OTC deals did not.  Nonetheless, given AIG’s stellar credit rating (as farcical as that seems in retrospect), it could have readily funded massive CDO CDS positions; and given its appetite for this risk, likely would have done so.

In sum, although clearing, and the margining it entails, would have increased AIG’s costs of trading derivatives, I seriously doubt that it would have caused the firm to reduce its positions substantially.

But, if I am wrong, and collateralization via a clearinghouse would have caused AIG to cut back dramatically on its positions: would things have been better? Not likely.

Note that those trading with AIG were typically doing so to hedge—to lay off—the risk on positions in structured products they held on their books. And remember, who were these firms that were trading with AIG? The very same banks considered to be so essential to the survival of the financial system.

Assume for a moment that these firms’ holding of these structured products built on subprime loans would have remained unchanged even if they had not laid off the risk on AIG. Then, if AIG had taken smaller positions, these firms would have borne more risk. When real estate prices tanked, and took the value of these securities along with them, these firms would have taken a bigger loss than they did in actual fact because in the event AIG absorbed some of the losses on these positions. What this means is that the big banks the government has felt necessary to bail out indirectly through AIG would have required a bigger direct bailout because they would have suffered larger losses on their CDO portfolios.

Given the size of the CDO positions, the amount of loss would have been the same regardless of how many CDSs AIG bought.  The only thing that AIG’s trading did was affect the allocation of those losses; the losses were shifted from the banks that held the CDOs to AIG.  Recall that Treasury and the Fed deemed that the losses these banks would have suffered after AIG had absorbed a huge portion of the loss would have jeopardized the financial health of these firms.  Their health would have been in a more parlous state had AIG Financial Products never been born, as they would have had to absorb all the loss, rather than share some of it with AIG’s shareholders. Sure, an AIG bailout wouldn’t have been necessary without AIG, but an equally large, or larger, bailout of the banks holding the (unhedged) CDOs would have been required.  In effect, AIG’s shareholders bailed out the banks holding the CDOs, but didn’t have enough capital to do the job itself.  Uncle Sam kicked in the rest.

Now we’re approaching the end of the argument.  Holding AIG positions constant, clearing wouldn’t have reduced the size of the bailout, and likely would have increased it.  Even if clearing would have reduced the size of the firm’s positions, or even if AIG FP had never been born, holding constant the size of the underlying CDO positions that banks hedged through AIG, the size of the bailout would not have been decreased, and likely increased.

So, this means that AIG’s existence, or the scale of its activity, would have affected the severity of the financial crisis  only if they  had affected the amount of CDOs outstanding, and ultimately the amount of subprime debt issued.

Is this realistic?  It is certainly plausible that if AIG had traded less, or not traded at all, that (a) the cost of hedging CDO risk would have increased, (b) hence, banks would have held smaller CDO positions, (c) this would have reduced the demand for subprime debt, leading to (d) a less severe financial crisis.  But the magnitude of the impact of AIG’s actions on the size of the CDO and subprime markets was arguably not very large.  Myriad economic and political forces were behind the housing bubble and the growth of subprime and the associated explosion of structured finance.  Lax monetary policy, massive savings by China and Japan, tax subsidies for housing, policy initiatives to boost home ownership among those who could not afford it via conventional financing methods, the implicit government guarantee of Fannie and Freddie, pervasive belief that subprime finance and the associated structured finance were not risky, among other things,  all contributed to the boom and subsequent bust.  Disentangling AIG’s effect from all those other factors is difficult.  But it is likely that the AIG effect by itself, against the background of all these other factors, was small.  This is especially true when one considers that given the widespread beliefs at the time, that if AIG hadn’t done it, somebody else would have.

So, contrary to Time Magazine (surprise, surprise), AIG was not the real WMD.  It was, in effect, the particular channel through which the financial flood traveled.  The underlying causes of the flood lie elsewhere.  AIG is a symptom, not primary cause.

Indeed, given the underlying causes, the damage likely would have been worse for other financial institutions, and for taxpayers, had AIG FP never been born.  Moreover, the “solutions” du jour, namely clearing, would have probably made things worse by concentrating the impact on a smaller number of systemically important financial institutions.

AIG is insolvent.  That is not a good thing.  But consider this analogy.  A flood far more extensive than anyone believed possible occurs.  Believing the risk of a massive flood to be small, many people had built homes and businesses in an attractive area that they believed to be safe, only to have them inundated by the historic deluge.  A company had insured these houses, also believing the risk to be low.  The losses were so large, that the company was wiped out.  It had enough capital to cover some of the losses suffered by those it insured, but not all.  The government stepped in, and bailed out (financially) the homeowners, covering the losses the insurer could not.

So the questions: Would the world have been better had the insurance company not existed?  Would the taxpayers pay more, or less, had the insurer not existed?

The answers to these questions seem, to me, to be “No.”  Only to the extent that the existence of the insurance company encouraged building that, in retrospect, was imprudent would the answers be different.  And, if belief in the impossibility of such a flood was widespread, it is highly unlikely that the absence of the one insurance company that drowned in it would have had a significant impact on the number of houses built, and the economic damage suffered.

I think that the analogy is a good one.  AIG is the “seen” effect of the financial crisis.  It is the tangible evidence of its existence.  It is a conduit by which the crisis spread.  But it is not the cause.  The unseen, or the difficult to see (because of the complexity of the reality), is the true cause.

There are several meta-lessons here.  One relates to the role of derivatives.  Derivatives are, first and foremost, means of allocating risk.  They do not create it.  They shift it.  Now, the existence of a risk shifting tool, by reducing the costs of bearing risk, may lead people to make different economic decisions than they would in its absence, and this effect could influence the size of losses that occur.  But, for the most part, derivatives merely transfer the burden of economic losses, rather than affecting the magnitude of these losses.  Indeed, this shifting of risk typically reduces the cost of bearing it.  Even if a company, like AIG, fails spectacularly because of the losses it incurred in the derivatives market, that does not mean that the derivatives are bad.  That, again, is the seen.  The unseen is who would have lost, and how much more damaging that loss would have been, if some of it had not been shifted to the company that failed.  If the company had not born the loss, who would have?  Would they have been better able to bear it? The balance of the argument, to my mind, weighs strongly on the side that says the effects of the loss would have been more severe had AIG not existed.  The unseen alternative not chosen would have been worse than the seen.

There is a related meta-lesson.  I often say that one of the great lessons of the Great Depression is that people learned the wrong lessons from the Great Depression.  We are in the process of repeating that experience today.  By focusing on the observed spectacular failure of one company, pundits, and more importantly policymakers, are devising regulatory and legislative responses that do not address the true causes of the ongoing crisis, may make future crises worse, and which are likely to reduce the efficiency of markets going forward.  Mandatory clearing is just one example of that.  Geithner’s and Bernanke’s demand for sweeping discretionary powers over non-bank financial firms is another.  AIG is the poster child for these efforts.  But the focus on AIG distracts attention from the real issues.  As a result, as in the 1930s, we are likely to create a vast regulatory structure that will not make our financial system any safer, but which will impede the ability of markets to work effectively and efficiently.