Archive for the ‘bailouts’ Category

Rot at the core: Fed Vice Chair Don Kohn`s Senate testimony reveals the Fed’s moral hazard maximizing strategy (h/t Willem Vuiter at the FT)

March 7th, 2009 No comments

The March 6 Financial Times has a great piece by Willem Vuiter, professor at the LSE and former chief economist of the EBRD, that completely rips the Fed`s bailout of AIG`s credit default swap counterparties, as emblembatic of the epidemic of moral hazard that has rotted out our financial system. 

Vuiter doesn`t focus on the dynamics that led to the problem (limited liaibility by shareholders, which has led to a vacuum in risk management, as no one had enough “skin in the game”), but correctly notes that the Fed`s actions incentivize further irresponsiblity – and that the Fed and Congress themselves don`t have enough skin in the game, as they are playing with taxpayer money, not their own.

The article is worth reading in whole; here are excerpts of the parts that resonated most with me (emphasis mine):


The reports on the evidence given by the Vice Chairman of the Federal Reserve Board, Don Kohn, to the Senate Banking Committee about the Fed’s role in the government’s rescue of AIG, have left me speechless and weak with rage.  AIG wrote CDS, that is, it sold credit default swaps that provided the buyer of the CDS (including some of the world’s largest banks) with insurance against default on bonds and other credit instruments they held.  Of course the insurance was only as good as the creditworthiness of the party writing the CDS.  When it was uncovered during the late summer of 2008, that AIG had nurtured a little rogue, unregulated investment banking unit in its bosom, and that the level of the credit risk it had insured was well beyond its means, the AIG counterparties, that is, the buyers of the CDS, were caught with their pants down.

Instead of saying, “how sad, too bad” to these counterparties, the Fed decided (in the words of the Wall Street Journal), to unwind “.. some AIG contracts that were weighing down the insurance giant by paying off the trading partners at the full value they expected to realize in the long term, even though short-term values had tumbled.”

An LSE colleague has shown me an earlier report in the Wall Street Journal (in December 2008), citing a confidential document and people familiar with the matter, which estimated that about $19 billion of the payouts went to two dozen counterparties between the government bailout of AIG in mid-September and early November 2008. According to this Wall Street Journal report, nearly three-quarters was reported to have gone to a group of banks, including Société Générale SA ($4.8 billion), Goldman Sachs Group ($2.9 billion), Deutsche Bank AG ($2.9 billion), Credit Agricole SA’s Calyon investment-banking unit ($1.8 billion), and Merrill Lynch & Co. ($1.3 billion).  With the US government (Fed, FDIC and Treasury) now at risk for about $160 bn in AIG, a mere $19 bn may seem like small beer.  But it is outrageous.  It is unfair, deeply distortionary and unnecessary for the maintenance of financial stability.

Don Kohn ackowledged that the aid contributed to “moral hazard” – incentives for future reckless lending by AIG’s counterparties – it “will reduce their incentive to be careful in the future.” But, here as in all instances were the weak-kneed guardians of the common wealth (or what’s left of it) cave in to the special pleadings of the captains of finance, this bail-out of the undeserving was painted as the unavoidable price of maintaining, defending or restoring financial stability. What would have happened if the Fed had decided to leave the AIG counterparties with their near-worthless CDS protection?

“I’m worried about the knock- on effects in the financial markets. Would other people be willing to do business with other U.S. financial institutions…if they thought, in a crisis like this, they might have to take some losses?”

Let’s step back a minute and ponder this.  US banks and shadow-banks (like AIG’s Financial Products Division) took on excessive leverage and excessive risk.   There was not only too much careless lending by US banks, there was too much careless lending to US banks.  When this crisis is over and when, in the fullness of time, the real economy has recovered, we want to see less lending by and to US banks than we saw in the years 2004 – 2006.  How do we get those who provided US banks and other financial institutions with too much funding at too low a cost to behave with greater prodence and caution in the future? Presumably by making sure that they pay the price for there (sp) reckless financial decisions.  The counterparties of AIG who had been unwise enough to buy insurance against default on debt instruments they held, by acquiring CDS written by AIG should have been told to eat it.



Unless the counterparties pay the full price for their hubris and recklessness, they will be back for more.  It is therefore tragic that central banks and governments everywhere are going out of their way to protect and shelter the unsecured creditors of the banks (holders of junior and senior debt among them), by raiding the tax payer or the credit and reputation of the central bank.  Significant mandatory debt-to-equity conversions and large write-downs of (haircuts on) the claims of other unsecured creditors should be an integral part of any financial assistance package. …

While the demise of Lehman and the destruction of most of its unsecured creditors was an unnecessary surprise, it was still the best option available to the authorities, given the absence of an SRR [Special Resolution Regime].  Markets and market participants are educated only by painful example.

The cardiac arrest followed the realisation, well after Lehman went kaput, that (1) most of the internationally recognisable US banks were insolvent or would be but for past, present and anticipated future government financial support; that (2) many other non-bank financial institutions (AIG) and shadow-financial institutions (GE) were either insolvent or at death’s doorstep; and that (3) the government was not on top of the issues and the Congress was deeply divided and irresponsible.

The logic of collective action teaches us that a small group of interested parties, each with much at stake, will run rings around large numbers of interested parties each one of which has much less at stake individually, even though their aggregate stake may well be larger.  The organised lobbying bulldozer of Wall Street sweeps the floor with the US tax payer anytime.  The modalities of the bailout by the Fed of the AIG counterparties is a textbook example of the logic of collective action at work.  It is scandalous: unfair, inefficient, expensive and unnecessary.



Well said!


"Lemon Socialism" – liberal Obama advisor Robert Reich regrets the bailouts, but wants massive stimulus

January 26th, 2009 No comments

An opinion piece at TPM Cafe by liberal economist Robert Reich the Harvard (now Berkeley) econ. prof. who is a member of Pres. Barack Obama‘s economic advisory team and was Labor Secretary under Bill Clinton –  has caught my eye.  In it, Reich correctly, on behalf of the American taxpayer, expresses buyer’s remorse with respect to all of the bailouts – and lemon industries – that the Bush administration, via Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke and a complaisant US Congress, have bestowed on the American people and the Obama administration.

It’s nice to see a liberal economist who regrets the bailouts and opposes further TARP expenditures; too bad he doesn’t see that a massive stimulus program and other government economic micromanagement is a great way to turn the rest of the economy into “lemon socialism”.  

Categories: bailouts, Robert Reich, socialism Tags:

Kristof gets Japan’s "lost decade" wrong; argues for a US lost decade by supporting the auto bailout

December 15th, 2008 No comments

New York Times columnist Nicholas Kristof argues on Sunday that an auto industry bailout is needed given the importance of the industry to the US economy, and bases his conclusion on how economic mismanagement by Japan resulted in the “lost decade” there; his blog summary is a good precis of his column:

My Sunday column argues for bailing out the auto companies. It’s not that I think the arguments against a bailout are wrong — in general, businesses should have to have the freedom to fail — but conditions are so precarious right now that we just can’t afford another huge blow to employment and consumer demand. It may well be cheaper for taxpayers to sustain General Motors than to pay for the clean-up and burial if it expires.

I should add that my view on this is deeply shaped by my years living in Japan during the “lost decade” there. Anyone who watched the torment of Japan, and the failure of government to address it sufficiently aggressively, believes that we should err on the side of action.

It seems to me that, from my vantage point (in Japan in the 80s and since 2000, and observation of the US S&L liquidations), Nick Kristof has got the lessons from the Japan “lost decade” all wrong.  I said as much on his blog, and copy below the comments I left him:

Anyone who watched the torment of Japan, and the failure of government to address it sufficiently aggressively, believes that we should err on the side of action.

Nick, I think you fail to understand Japan’s lost decade, which certainly involved the government acting to provide massive capital support to prop up banks, thereby allowing zombie companies to survive, while further wasting public funds on roads and bridges make-work projects.

The Japanese would have been much better off either with (1) aggressive bank takeovers, liquidations and asset workouts – a la the US method in dealing with failed S&Ls, or (2) with doing absolutely nothing, which would have resulted in bank failures and the death of zombie companies.

Why are these better than direct bank bailouts or industry bailouts?  Because they stop wasting public and private capital on failed businesses, put idle assets in the hands of people who can do something positive with them, and contribute to growing economies.

Public intervention in the form of bailouts is pernicious because it not only lets politicians pose as doing something, but further takes wealth from private hands (either in the form of taxes, or borrowed capital that raises borrowing costs for others) and instead of letting private markets determine what are the most profitable areas for investment.  At their core, bailouts are actually a tax on future recoveries.

Categories: autos, bailouts, Japan, Kristof Tags:

Beggar’s Banquet: a note on bailouts to the NYT’s Tim Egan

November 28th, 2008 No comments

Timothy Egan, reporter, acclaimed book author and current columnist at the New York Times, posted an honest and understandably  confused piece last week, in which he called for a temporary end to the frenzy of Bush-era socializations and wealth-transfers – so at least Obama will have a chance to try sometihing REALLY helpful when he comes into office.

Here’s what I had to say to Tim in comments:

Tim, the right answer is the old answer – no bailouts. 

Let firms, towns and states with problems take care of them themselves.  Unless we are talking about a voluntary community effort, bailouts are just a way for politicians to look good while they move money from those who make money to those who lose it, and is a further drag on investment and economic growth.

So would be a “green” jobs plan by Obama – far better to level the playing filed by eliminating ALL energy subsidies than to have the corrupting and senseless distortions we get from the hand of government.  Perhaps a carbon tax at the production end could be justified, but only if the revenues were rebated to citizens pro rata to provide incentives while avoiding regressive pain [and pork].

The government’s efforts to “solve” the problems that it is even now encouraging by socializing risk show promise only of paralyzing personal responsibility and initiative, sucking up capital and recreating the Great Depression.

Categories: bailouts, green jobs, obama, Tim Egan Tags: