Not Quite Crony Capitalism?

I haven't read this yet, but Lucas Puente -- a PhD student at Stanford -- has an interesting-looking article in the new PS (I don't see an ungated version). Abstract:

I investigate one mechanism through which financial institutions could have used political influence to receive preferential treatment in the US Department of the Treasury-administered “bailout.” I find that neither proxies of political influence nor other political variables, such as public interest in specific deals, can explain variance in the sale price of warrants (a type of financial asset) Treasury acquired through TARP's Capital Purchase Program. Moreover, I find that the more politically active the firm is, the more likely Treasury is to auction its warrants (thereby receiving fair market value). This conclusion is not consistent with recent studies investigating the role of such variables in the initial administration of TARP and can be interpreted as good news for American taxpayers.

PS summary (bold added):

In the wake of the recent global financial crisis, many have suggested that the US government's administration of the taxpayer-funded rescue of the financial industry offered disproportionate benefits to politically active firms. However, quite the opposite occurred. Puente's research into Treasury's handling of the disposition of warrants (assets similar to stock call options) acquired through the Capital Purchase Program (CPP) shows that, at least in this phase of the "bailout," political variables did not matter. That is, lobbying expenditures, campaign contributions, and connections with Secretary of the Treasury Geithner, among other independent variables, cannot explain variance in the percentage of market value Treasury received for these warrants. Moreover, according to Puente, the more politically active a firm is, the more likely Treasury is to auction its warrants (thereby receiving fair market value). This suggests that Treasury is attempting to counter-act allegations of preferential treatment. Taxpayers should be pleased. By insulating itself from politics and making efforts to maximize the taxpayer return on the warrants, Treasury may have prevented billions of dollars in taxpayer losses.

I personally don't find this very surprising. Nor would I find it surprising if preferential treatment came mainly through less transparent channels, e.g. the Fed. It looks like Puente might be investigating that question in his ongoing research.

OMG WTF Federal Reserve Fact of the Day

Via Felix Salmon:

At the end of 2010, the Federal Reserve system had $2.423 trillion in assets and $2.367 trillion in liabilities, which means that the simplest measure of its total equity — assets minus liabilities — comes to $56.6 billion. The Fed also managed to earn net income of $80.9 billion in 2010. Which means that its return on assets was incredibly high at 3.3%, while its return on equity was an astonishing 143%.

I think it’s fair to say that no bank in the history of the world has ever had income of anywhere near $80 billion in one year: that’s over $700 per US household. Somehow, the Fed is making roughly $60 per household per month, and remitting that money straight to the Treasury.

Much of this is TARP, but also QE1 and QE2. On net I'll take it as a good thing that the Fed is giving billions to the Treasury, but the scale of interventions in asset markets is so large that it can't but make me nervous.

This is also another reminder that the U.S. Federal Reserve is the most powerful and important actor in the global economy, bar none. Its actions have far-reaching ramifications, and its capabilities are enormous. Sometimes that's good. Other times, probably not.

Or, it's better to say that when the Fed acts, it can help some groups quite a lot, and can devastate others.

Why TARP Was Good, and Why Bailout Guarantees Are Necessary

The CBO has once again lowered its estimate of the cost to taxpayers of TARP. It's not down to $25bn, from an expected $109bn in March. At this rate, the program might make a profit overall, rather than just a profit from the bank portion of the program. Even if it loses $25bn, it's hard to argue that that's poor value for money, as Ezra Klein and Jon Chait point out.

Ryan Avent is not convinced. He says that the success or failure of TARP cannot be measured solely in dollars, but also in how it reshaped the political economy of finance in a way that exposes taxpayers to future defaults:

But to cite the dollar cost of the bill and declare it a roaring success is to totally misunderstand what TARP actually did. ...

What's important to realise is that built into the rise in value of the companies backed by the government (the banks especially) is the government's guarantee against failure. The government hasn't yet withdrawn this guarantee, and so it's still on the hook. President Obama could go before the country and say, "Ok, having sold our shares we now promise to never again bail out troubled companies". Markets would go "Ha ha ha", and continue behaving as if the government was still on the hook. Because it is. ...

But having convinced markets that the banks won't be allowed to fail, the government has accepted some set of unknown future obligations, which are growing all the time thanks to the moral hazard of the government guarantee. ...

So what has TARP cost American taxpayers? The correct answer is: we don't know. It's almost certainly less than the cost of the Depression that would have resulted from cascading failures at the nation's largest banks. But it's a lot more than $25 billion.

I think this is exactly wrong. The first wrong thing is thinking that a bailout guarantee didn't exist before the crisis. It did. The pattern of U.S. government intervention into financial markets, from the Latin American crisis (using the IMF) to LTCM, always suggested that the government would step into to prevent financial collapse. This was the Geithner plan, forged from his experiences in the Tequila and Asian crises. The Bear Stearns deal in March, 2008 reinforced that pattern. The exception was Lehman, and that's why the Lehman collapse was so devastating: markets expected the government to intervene when necessary. When it didn't, it set off a major panic. That is not something we should be keen to replicate.

The second wrong thing is to think that this is bad. As I wrote some while ago:

At some point in the future some financial institutions will become illiquid. If the government makes a credible commitment to not provide funds to those distressed institutions, then the first sign of trouble will touch off a run on those firms. Bank runs are contagious, so even if only a single firm is affected initially, the trouble could sink the whole system. It's much better for the government to instill confidence in the system by guaranteeing that they will support illiquid firms than to guarantee that they won't.

And:

How do escape the vicious cycle of bank runs? The government intervenes by guaranteeing the funds of depositors. This intervention may be costly, but is much less costly than continuing to let a panic eat the financial system from the inside out. Nevermind the fact that the government cannot make a credible commitment to not bailout systemically-important financial institutions: it would be a bad thing if they could! Such a commitment would lessen confidence in the financial system and thus make runs more likely, not less.

Of course there are concerns about moral hazard, but there are ways to address these without pretending the U.S. government can make a commitment to not bail out financial firms when everyone knows they will if things get bad enough. For example, the government can protect counterparties and depositors while still punishing bank management and shareholders.

In fact, some governments choose to do this. Guillermo Rosas wrote a very good paper (pdf) in 2006 describing why some governments opt for bailouts, while others follow Bagehot's advice to shutdown illiquid firms. Rosas also has a book on the same topic, which I've not yet read.

The point is that we can make the punitive cost of intervention severe enough for bankers to restrict moral hazard, while still working to maintain confidence in markets and prevent runs. This is what we should do. (Note that my view has shifted on this over time; at the height of the crisis I was unconvinced that punitive damages were a good idea, but now I think they are. For management and shareholders at least.)

Avent argues that TARP cheerleading is damaging because moral hazard prices in that we will bail out distressed firms automatically in the future. I worry about the opposite: that the TARP slagging (by progressives and Tea Party types alike) weakens confidence in markets and makes the system more susceptible to damaging bank runs. Perversely, this could make public intervention more likely rather than less. To see an example of this in real time, look at the tepid commitment from the EU to support the PIIGS. If they had made a bigger commitment at an earlier date, the overall cost of intervention would likely have been much lower.

In other words, we don't want the political equilibrium to shift further away from engaging in emergency actions to stabilize teetering markets. That's the world of the 1930s. If we can make a commitment to maintain stability in financial markets (thus benefiting the country at large) without rewarding financial managers and shareholders for profligacy (thus hurting those that took excessive risks without harming innocent bystanders), then we definitely should. I'm not saying that we did that effectively in this crisis, but that should be the goal.

So here's the story we should be telling: TARP was an exceptionally successful program. The best thing about it was that it stabilized markets at relatively low cost, and perhaps even a profit. The worst thing about it was that it was not severe enough towards management and shareholders. But we can fix that the next time this happens. We can pass legislation today that if financial firms require government bailouts, they come with harsh penalties. We should not throw out the good with the bad, and we don't have to. We should always insist that we will do whatever is necessary to maintain confidence in markets, but in so doing we will try very hard not to reward those that make bad investment decisions. They should be forced to bear the cost of their actions.

I'm not sure if there's a winning political coalition for that perspective right now. The financial industry obviously wouldn't appreciate that sort of commitment. Neither would most progressives, libertarians, or Tea Party conservatives. But that's that the narrative we should present.

TARP Still Making Money

Bloomberg:

The government has earned $25.2 billion on its investment of $309 billion in banks and insurance companies, an 8.2 percent return over two years, according to data compiled by Bloomberg. That beat U.S. Treasuries, high-yield savings accounts, money- market funds and certificates of deposit. ...

The $25 billion TARP return could fund the SEC for more than 20 years, based on the agency’s proposed 2011 fiscal year budget. It could pay for all farm subsidies in the U.S. for more than two years.

I've been beating this drum for awhile now, but it's worth returning to every now and then. We didn't lose hundreds of billions saving the banking sector. We bought depressed assets at low prices. Now that the assets are appreciating in value, we're making money.

True or False?

1. "Private regulation generally has proved far better at constraining excessive risk-taking than has government regulation.”

2. "If a small-enough-to-fail bank takes too many risks and fails, the systemic consequences are manageable. If a TBTF bank takes too many risks and fails, it can drag down the entire economy."

Both come from here. The first is Alan Greenspan in 2005, but he has since recanted. The second is Felix Salmon, arguing that we should chop down too-big-to-fail banks until they are small enough to fail.

#1 is interesting to me, because Salmon seems to think that it is an obviously false statement; even its originator disagrees with it now. But I'm not necessarily convinced. First of all, what does Salmon mean by "government regulation"? Well, according to this post he means the Federal Reserve. Is it true that the Federal Reserve has proved better than market discipline at constraining excessive risk-taking by banks? I believe that's an open question. That doesn't mean that markets are perfect; but surely regulators aren't either. Is it obviously the case that regulators are less flawed than markets? Neither performed well in this crisis.

When you have systemic collapses, it's because you have systemic failures in risk-pricing. That means both markets and regulators get it wrong. But look statement #1 again: I think there is a strong case to be made that in general markets do a better job of disciplining banks than governments do, even if I accept that markets did worse in this particular case.

Now, about #2. Is it really the case that small banks can't cause systemic collapses? Well I guess you can do what Salmon does and make the answer tautological. If a bank collapses and sets off a broader collapse, then it was ipso facto TBTF. But Salmon is talking about chopping up TBTF banks until they are a manageable size. But how big is too big? Bank Herstatt wasn't very large, but it caused quite a bit of damage. The Great Depression was not caused/exacerbated by the collapse of one or two TBTF institutions, but rather by the spread of panic throughout the entire system. Smaller community banks failed first, touching off a panic that led to bank runs that caused other banks to fail. It's simply not true that we're protected from a systemic banking crisis if we limit the size of financial institutions.

Suppose we all do as as Salmon and others are asking, and move our money from large TBTF banks to smaller community banks. What happens the next time a panic enters financial markets? If we can isolate a handful of very large institutions, we can stabilize the system by stabilizing those few institutions. But if market power is much more diffuse, then containing the contagion is much more difficult: counterparty obligations can still have cascading effects, but it's more difficult to see how, when, where, and why. You may end up having to bailout or nationalize the entire banking system rather than just a handful of institutions.

In other words, perhaps TBTF is actually the best scenario. It allows us to focus recovery efforts where they can do the most good.

UPDATE: I should say that I'm not actually persuaded that any of this is actually right. Just thinking out loud.

Why We Shouldn't Be Worried About Inflation... Yet

Munger disagrees with my optimistic take on the Fed's profit:

Here's the thing: if inflation cranks up, the Fed is going to have to unload a buttload of debt, really fast. The only way to sell that much debt, and take excess cash out of the economy, is to sell at fire sale prices.

So, if there is inflation, the Fed is going to take truly ginormous capital losses on the debt it will have to sell. But this is exactly Bernanke's plan, the one he is so sure will work to prevent inflation. Big Ben's talk at the AEA meetings made much of this policy. But who in the world is going to buy CDOs in this market?

The lagniappe: Lots of the CDOs are based on fixed interest rate mortgages. If there is inflation, the capital value of those gets hammered. All the rest are based on ARMs of some kind. And for those the PAYMENTS skyrocket with nominal interest rates, and defaults go up, and AGAIN the CDOs' capital value takes it right up the ol' gazoch, with a red hot poker.

This is not really a good policy.

All of this is true... if inflation cranks up in the short-run. What do the markets think about inflation? Here is the most recent TIPS spread (the difference between nominal T-bills and inflation-protected T-bills, which represents the market's expectations about inflation):



This indicates that the market does not anticipate inflation to "crank up" any time soon. In fact, it means that we are at a much greater risk of deflation than inflation. Which means that the Fed policy is actually a very good policy, given the circumstances.

Of course, Munger is free to disagree with the markets if he pleases, but a libertarian should do so at his own risk.

As Krugman says, the danger that we'll end up in a Japan-style situation is much greater than the danger that we have rampant inflation in the short-run. In the medium-run, sure. But by then the Fed will have had plenty of time to off-load its risky assets at acceptable prices.

The Bank Tax

Here are some quick-fire thoughts about Obama's bank tax:

1. This is a essentially a tax on risk, because it targets leverage ratios. In terms of economic theory or even social justice this makes some sense. Think of it as a Pigouvian tax: moral hazard exists for firms with an implicit explicit government guarantee, so this tax could help bring private and social costs in line. In other words, it could help banks internalize the social costs of their actions. Especially, as Daniel Indiviglio says, if the proceeds from the tax were put into a "rainy day fund" to be used only if/when banking rescues need to happen again. That isn't going to happen, but I guess that doesn't make too big of a difference.

In practice, of course, it isn't going to work like that since banks will be able to pass some or all of the tax onto consumers. This view is supported by the fact that banks seem to have no problem at all with this tax. In fact that could be the best outcome. If banks are somehow forced to pay the tax themselves, it could actually create perverse incentives for banks to lever up even more to offset the loss of revenue from the tax. There is an argument [pdf] that this was the effect of capital adequacy requirements when combined with risk-weighting and the Recourse Rule, and that that created or exacerbated the financial crisis we're still digging out of.

2. The Obama administration could just target leverage ratios directly by mandating prudential standards. But that couldn't happen for several reasons. First, because it would put American banks at a competitive disadvantage in globalized markets (unless it happened under the auspices of the Basel Committee, which it might). Second, because it wouldn't raise any revenue for the Treasury, which could use it right now. Third, because it's a good political move to tax the banks even if it doesn't have the desired effects. The public is seeking its pound of flesh right now, and a "Bank Tax" could help stem some populist rage, even if the public are the ones who ended up paying it.

3. The government is making money off of the bank "bailout". I'll repeat that: the government is making money off of the bank "bailout". Quite a bit, as it turns out. It's losing money on the "Main Street" auto bailouts and AIG, but not the banks. Now, this doesn't count the loss in tax revenue (from decreased economic output) that the financial crisis caused, but it does stand for something.

UPDATE: Mankiw makes some similar points.

The Fed's Profit

Yesterday it was reported that the Fed earned about $46bn last year, mostly because it diversified its portfolio into riskier assets as a way of injecting capital into the banks. Fed payments to the Treasury also increased, and were north of $20bn.

This is unequivocally good news. Combined with the profits from TARP (at least the banking interventions), and it now appears that the government may make as much as $100bn from the interventions into the banking sector. That's right: not only did it not cost us trillions, as some claimed, or even the hundreds of billions of TARP outlay, but there will be a substantial profit.

Last fall, a lot of more liberal commentators like DeLong and Krugman were advocating a Swedish-style nationalization of the banks. As DeLong put it, if the government was sharing downside risk with banks it should share in the upside as well by acquiring equity stakes. Now we see that the government was sharing in the upside by buying depressed assets at low prices, waiting for the markets to stabilize, and then selling them back. All without having to bother full nationalization and the pitfalls that may have entailed.

This is very good news indeed.

TARP Makes More Money

Wells Fargo is paying back all $25bn it got from TARP, and the government will make about $1.5bn in the exchange. Citi is also paying back $20bn, although they'll still owe some.

The Curious Case of the Missing $100bn

The WSJ says that the Obama administration expects to lose $141bn from TARP, down from previous estimates of $341bn. The NYT says that the Obama administration expects to lose $42bn from TARP, down from previous estimates of $341bn. It's not that I'm not grateful, but where'd the NYT find that extra $99bn?

Turns out, it's buried:

The officials said the government could ultimately lose $100 billion more from the bailout program in new loans to banks, aid to troubled homeowners and credit to small businesses.

But that's the pessimistic projection, and I'm feeling good today. Check it out: the bank bailouts, subject of much consternation and populist rage, will actually make the government money. About $19bn, in fact. A certain somebody saw this one coming. So where are these losses coming from? Main St. (and London):

The estimated $42 billion in losses is a net figure that accounts for some profits to offset the losses. The Treasury officials said the government had lost about $60 billion, roughly half to Chrysler and General Motors and the other half to the insurance giant American International Group.

Had we not bailed out GM and Chrysler, we could've saved the entire global economy for about $30bn, maybe less. Call me a statist, but I think that's a friggin' bargain.

Should We Have Nationalized the Banks?

Economics of Contempt writes:

Paul Krugman is clearly confused. Regarding Citi and BofA, he writes:

Um, weren’t we being assured that recapitalization by the government — which would probably require temporary nationalization — was unnecessary, because the banks could earn their way back to adequate capital ratios?

Just saying.

Um, what? Is Krugman really that unfamiliar with quarterly earnings reports?

Citi's Tier 1 capital ratio is 12.7%. Citi's Tier 1 common ratio is 9.1%, up from 2.75% last quarter and 4.8% in Q3-2008.
BofA's Tier 1 capital ratio is 12.46%. BofA's Tier 1 common ratio is 7.25%, up from 6.9% last quarter and 4.23% in Q3-2008.

For frame of reference, JPMorgan's Tier 1 capital is 10.2%, and their Tier 1 common ratio is 8.2%.

Just saying.

The question is whether TARP was intended to recapitalize the banks or to boost profits. (These two might not be mutually exclusive in the long run, but there are tradeoffs in the short run.) For relatively healthy banks like Goldman and JP Morgan, TARP funds were issued to shield the unhealthy firms from bank runs: if all the banks were getting government money, investors wouldn't know which ones were insolvent. But it is now clear that Citi and BoA needed TARP to recapitalize, while Goldman and JP Morgan mostly needed to roll over some paper (or didn't need TARP at all) but were otherwise alright. In other words, Goldman and JP Morgan were solvent but illiquid at worst, while Citi and BoA were basically insolvent.

So they forego profits for a few quarters to recapitalize; a $1bn quarterly loss isn't much when the capital ratio has multiplied several times over the same period. So TARP worked, and banks have recapitalized. Without nationalization. So the "nationalize the banks like the Swedes did" folks were wrong.

Just saying.

P.S. Another question is why Citi and BoA overshot: 12-13% Tier 1 ratios are treble the Basel requirement, and more than twice as high as the "well capitalized" marker as well. If these regulations actually constrain bank behavior, then why are they voluntarily holding more capital then necessary (it's not just a reaction to the crisis; banks routinely have capital ratios well above the mandated minimums)? I plan to write more about this soon.

How Basel Worked Against TARP

In a post over at the Stash, Zubin Jelveh looks at whether TARP actually increased bank lending:

Banks did appear to use some of their TARP funds to increase lending. To arrive at his conclusion, Taliaferro compared different metrics of otherwise similar TARP and non-TARP banks in the months after the financial crisis began:

Based on a matched sample of participating and non-participating banks, of each dollar of new government equity they received, participants used roughly fifteen cents to support increased lending, while they used roughly sixty cents to increase their regulatory capital ratios.

This chart from the paper, displaying the fraction of TARP funds used for different purposes, shows that the average bank also directed some of their new capital towardsof their capital to boost earnings:

Excusing the typo, I think what Jelveh is driving at is that banks used TARP money in three primary ways: to increase lending, to pad earnings statements, and -- most importantly -- to boost their Tier 1 capital ratios.

Banks had to maintain high capital ratios to meet their Basel requirements, which uses a risk-weighting scheme to determine the required adequacy ratio. At the end of last year and beginning of this year, bank capital was decimated by the financial crisis, but banks still had to maintain their ratios. So as soon as they got access to capital from TARP they simply plugged the holes, which meant they had less cash to lend than they would have had if the ratio requirements had been temporarily relaxed.

That doesn't mean that they shouldn't have used any of the money to recapitalize. Of course that was need too. But 4 times as much TARP money was used to boost capital ratios than to actually get money moving through the system, which was TARP's ostensible purpose. So in a sense, Basel was working against TARP, and made it much more expensive for Treasury to get lending moving again. If regulations were countercyclical, this wouldn't've happened and TARP might have gotten much more bang for its buck.

The Bailout:

Not a bailout.

It's Earnings Season!

Goldman Sachs, the investment bank, today announced that its second quarter earnings rose to $3.44 billion, and that it had put aside $11.4 billion for salaries, bonuses and benefits in the quarter, up by nearly half from a year ago.

At that rate, Goldman employees could, on average, earn roughly $770,000 apiece this year — or nearly what they did at the height of the boom.

Senior Goldman executives and bankers would be paid considerably more. Only three years ago, Goldman paid more than 50 employees more than $20 million apiece. In 2007, its chief executive, Lloyd C. Blankfein, collected one of the biggest bonuses in corporate history -- nearly $70 million. The latest headline results — $3.44 billion in profits — were powered by earnings from the bank’s secretive trading operations and exceeded even the most optimistic predictions.

Many analysts were surprised that Goldman posted such hefty prospects, especially since it was only last month that Goldman repaid the $10 billion that it received from the U.S. Treasury Department in October. Although it is widely believed that Goldman was required to take the funds, even though they probably didn't need the extra capital.

Megan McArdle comments on why these profits shouldn't have come as such a surprise:

This is not actually hugely surprising, given that three of their biggest competitors went out of business or were acquired in the last year; as financial markets unfroze, Goldman, which had one of the cleanest balance sheets, was bound to see a hefty increase in their profits.

Goldman's stock price has also rebounded nicely, up about 77% since the beginning of the year. (Dammit, should've bought it!) It also turns out that by paying back the TARP monies last month, Goldman also freed itself from any government interference into their compensation practices, thus allowing Goldman to freely pay its employees these nice little bonuses.

Many are up in arms about paying these people so much money, even if they did as well as it seems they did this past quarter; McArdle addresses a bit of this in her post. But what are we supposed to do? Have the government intervene again, this time to cap pay inside a private corporation that made record profits, just because they made record profits while the rest of the economy is still tanking and unemployment is about to cross 10%?

I don't think that'd be a good idea; we already set a pretty bad precedent by bailing out the banks in the first place, even though it was probably needed to restore market confidence and recapitalize institutions that were in trouble. Further meddling, especially into the compensation practices of a financial firm not under government ownership, would be setting another bad precedent.