Posts Tagged ‘Finance’

Glass-Steagall Redux

Wednesday, October 21st, 2009

The New York Times reports today that former Fed Chair Paul Volcker’s call to forbid commercial banks from mixing with investment banks is falling on deaf ears within the Obama administration.  Volcker, head of the president’s Economic Recovery Advisory Board, believes keeping banks from owning and trading securities will keep them out of the trouble they have experienced in the current recession.

According to Smeal’s Jean Helwege, Volcker’s plan would likely make future economic crises less costly than this most recent one, however, it won’t keep the Fed from spending taxpayer dollars to bail out poorly run banks in the future.

More from Helwege:

Paul Volcker, former Federal Reserve chairman and adviser to President Obama, recommends that we go back to the good old days when commercial banks and investment banks were kept separate. The logic now, as it was in the 1930s when Glass-Steagall was enacted, is that investment banking is too risky a business to mix with consumer deposits. In a speech earlier this fall Volcker stated, “I do not think it reasonable that public money—taxpayer money—be indirectly available to support risk-prone capital market activities simply because they are housed within a commercial banking organization.” Volcker recognizes that his views are hardly “progressive,” noting that “people say I’m old-fashioned and banks can no longer be separated from nonbank activity.”  But he points out, “That argument brought us to where we are today.”

The $64,000 question is whether we would be where we are today had we pursued different regulatory policies leading up to this recession. Whatever the policies regarding mergers of banks and investment houses, we would have experienced a housing bubble and it would still have popped, bringing massive losses to homeowners across the nation and a retrenchment in homebuilding that would last years. Fannie Mae and Freddie Mac would still be in conservatorship, having overleveraged themselves to peddle the American dream of home ownership. Investors would still have lost money on mortgage-backed securities built on subprime mortgages. Those losses would still have led to concerns that safer mortgages might default, expanding the breadth of losses in the MBS market. We would be in a deep recession as a result of the housing downturn regardless of whether banking activities are segregated.

However, Volcker’s arguments are more geared toward preventing the next near-Great Depression and redefining the policy responses to such crises. If we still had Glass-Steagall, we would not have seen the merger of JPMorgan Chase (a bank) with Bear Stearns (an investment bank) in 2008, which might have prevented people from expecting a similar deal with Lehman and some other commercial bank and thus the fallout when Lehman was dropped like a stone from the list of firms “too big to fail.” If we still had Glass-Steagall, Goldman would never have decided to convert to a bank holding company and potentially would not have received the largesse it did. Nor would Bank of America have had its arm twisted into acquiring Merrill Lynch. Bringing back Glass-Steagall might bring us back to the days of more narrowly defined policy responses by the Federal Reserve. And it might mean that the next crisis will not be worse than today’s now that the investment banks are so strongly encased in the regulatory womb of the Federal Reserve.

Reinstating Glass-Steagall is a simple response to a complex issue.  While simple may be all we can swallow, it remains the case that the Federal Reserve has not been successful in striking a balance between helping out the economy and condoning bad behavior by financial firms.  The Fed identified AIG as strong enough to get a loan (i.e., the Fed was sure it would get paid back) and Lehman as incapable of repaying new funds. It deemed CIT too unimportant to deserve aid but was willing to help out the entire money market mutual fund industry. The Fed’s willingness to extend its hand to all manner of poorly run firms is a concern and Volcker’s efforts to rein in this independent agency may help, but unfortunately it’s more likely that the Fed will find another way to expand its role as lender of last resort regardless of whether we revert to Glass-Steagall.

Tags: Banking, Economic Crisis, Finance, Helwege, Politics
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America’s Trade Row with China: Weird Scenes Inside the Goldmine?

Wednesday, September 30th, 2009

A recent article in The Economist discusses President Barack Obama’s decision to impose a tariff on tires imported from China. Smeal’s Brian Davis weighs in on the issue by asking important questions about the repercussions of these actions.

The recent decision by the Obama administration to impose tariffs on imported Chinese tires– at first glance, (even second glance) seems “weird” from a rational economic perspective. Why would policymakers want to slaughter the golden goose of free-trade, especially when the domestic economy is still fragile following the events of the housing and banking crisis? Has Obama not learned the lessons of Smoot-Hawley?

Interpretation of the cause and effect of this action is probably more complex than a first-reaction rationale. On one hand, the tire tariff has relatively little effect on American consumers or workers. This is NOT Smoot-Hawley. Domestic producers have mostly abandoned the low-end tire market, with plenty of substitutes for Chinese tires provided by imports from Brazil and Indonesia. The larger question is whether or not this will spark a larger tit-for-tat trade war with China. An all-out trade war would have severe consequences for American exporters relying on access to the growing Chinese market for recovery. Will more special interest groups demand similar concessions?

The article highlights a worrisome trend, that import restrictions and other protectionist actions against China, by developed economies, have nearly doubled since 2007. Is the risk of sparking a trade war worth the chance that China will dismantle many of its trade barriers as a response to U.S. action?

One last perspective on these events is that the Obama administration has used the tariff issue as a bargaining chip to pressure China’s cooperation concerning Iranian nuclear ambitions. However, history has not been kind when countries attempt to use economic sanctions and other barriers to motivate political concessions. For now it’s a matter of wait, see and of course hope.

Tags: China, Davis, Finance, Trade
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Feel-Good Regulations

Friday, September 18th, 2009

Speaking on Wall Street this week, President Obama renewed his call for a Consumer Financial Protection Agency to “make certain that consumers get information that is clear and concise, and to prevent the worst kinds of abuses” by financial institutions. Smeal’s Edward Ketz, in a forthcoming column, says this proposed new regulatory agency amounts to little more than politics:

What Obama is really trying to do is give American voters the impression that he is in charge, that he cares about them, and that he is improving matters so that the chances of another financial meltdown is infinitesimal.  It is political legerdemain.

As long as managers have perverse incentives to cheat investors and as long as the SEC goes after only the little  guys and ignores managers at Enron, WorldCom, Madoff Investments Securities, and GE, nothing is going to change.  If the Congress and if the president want to improve matters—and I have no idea if they really do—then they must change the set of incentives and disincentives.  To effect real change, the system must punish managers and directors who lie and steal and cover it up with scandalous financial reporting.

More regulation might make society feel better, but that is just an indication that most Americans have little understanding of economics.  They will continue to lose in the stock markets until they insist elected officials do something substantive.

My fear is that Democrats will rally around Obama while Republicans vilify him, similar to the previous administration when Republicans rallied around Bush and Democrats denigrated him.  There is too much partisanship in this country and not enough rational analysis.  Americans need to understand that both presidents have failed us by supporting new legislation and by crippling better enforcement.  (For whatever it is worth, this is one of the reasons I am an Independent.)

Tags: Banking, Economic Crisis, Finance, Ketz, Politics
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Investing in Weather

Tuesday, September 15th, 2009

An article on CNN.com yesterday explained how traders might be able to make money betting on the weather:

You can actually make money speculating that the temperature in Sacramento, California, will be warmer than it normally is. If that’s too dull for your portfolio, you can put money down on the inches of snowfall next winter in Boston, Massachusetts, or the strength of hurricanes in the Gulf of Mexico. These kinds of investments, called weather futures, are trading through the Chicago Mercantile Exchange right now.

… The most basic type of weather-futures contracts allow traders to speculate on changes in the temperature. And in many cases, companies use them like insurance policies. When speculating on temperature, a buyer would pay a premium for the option to wager on future temperatures. If the temperature hits a specified level, then the buyer gets to collect the amount agreed upon by the seller. If it doesn’t, the seller keeps the premium and the contract expires.

How accurate are these weather futures markets? Researchers in Smeal’s Laboratory for Economics Management and Auctions set up some weather markets of their own, and found that the market forecasts were at least as accurate as the major public forecasting services that served as benchmarks for the research: AccuWeather, the BBC, CNN, and the National Weather Service. On average, the temperatures predicted by the Smeal weather markets have been off by only about 6.6 percent.

For more on the weather markets research, click here.

Tags: Economics, Finance, G. Bolton, Kwasnica
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The Case Against Pessimism

Wednesday, August 19th, 2009

The current issue of BusinessWeek makes “The Case for Optimism” in our economy by focusing on positive outcomes, including lower shipping rates and increased metal prices. Another reason to be optimistic? Research by Smeal’s Anthony Kwasnica finds that pessimism in our stock markets may actually be the cause of our struggling economy, rather than just an indicator of it.

Kwasnica says that short-selling and other techniques that reward negative performance communicate pessimism about the economy that can infiltrate the markets and may actually cause economic performance to dip into the negative. 

In the current U.S. economy, with the news media constantly focused on the stock market’s performance, the negative effect of perceptions can do even more damage, according to Kwasnica. As more and more bad news is conveyed by the stock markets, pessimistic beliefs are reinforced over and over again and the markets can make a bad economy worse, and do so quickly.

To get out of this vicious cycle, Kwasnica and his coauthors say there are at least two fixes that are already at work in the U.S. economy now. The first option is to quiet some of the pessimistic views on the economy by disallowing investors to profit from negative predictions that come true. The proposed rules regulating short-selling fall into this category.

The other fix is through leadership. The actions of a highly visible and trusted public leader may convey market confidence and instill optimism in other investors.

“Ultimately, some balance between government intervention and industry leadership must be struck to ease the negativity currently in our markets,” Kwasnica says.

Tags: Economic Crisis, Economy, Finance, Kwasnica
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Ponzi Pointers

Thursday, July 2nd, 2009

In an article on the Research/Penn State Web site, Smeal’s Edward Ketz explains how Ponzi schemes work and offers this advice for avoiding them:

A lack of clarity about the workings of an investment plan should be an immediate red flag. Investors should be skeptical if fund managers say things like “you wouldn’t understand” or “that’s private information.” Those types of claims are attempts to deceive.

Warren Buffet is one of the world’s most successful investors, and he has often said that he does not invest in anything he does not fully understand.  Those who follow his advice will not fall prey to a Ponzi scheme.

Tags: Finance, Ketz
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Financial Oversight Overhaul

Wednesday, June 17th, 2009

President Obama today unveiled a new financial regulatory structure aimed at preventing future economic meltdowns. Below, Smeal’s Jean Helwege explains the impetus for the new oversight rules and explores the regulatory strengths and weaknesses of the Fed and the FDIC:

A prominent element of President Obama’s plan is to create a systemic risk regulator. The idea is that one agency will be charged with regulating financial entities that pose a risk threat to the economy as a whole. This agency will ensure that firms that fit into the “too big to fail” category will be more prudent and thus taxpayers in the future will not be asked again to pony up billions to bail out reckless financial firms.  

The idea of a systemic risk regulatory really embodies two major reforms: consolidation of depository regulators and creation of a new body to focus on systemic risk. Our current system allows financial firms that offer deposits to choose one of several regulators: The Federal Reserve is the regulator for bank holding companies, such as Citigroup; the Office of the Comptroller of the Currency (OCC) is the regulator for nationally chartered banks;  and the Office of Thrift Supervision (OTS) is the regulator for savings and loans, which surprisingly is the charter chosen by AIG, American Express, and several other behemoths that are not typically thought of as depository institutions.

While AIG is mainly an insurance company and its insurance subsidiaries are regulated by state insurance commissioners, AIG finds it convenient to offer checking accounts to its customers, and therefore has a thrift charter. All of these deposits are insured by the Federal Deposit Insurance Corporation (FDIC), which became the single regulator for deposit insurance in the 1990s for most checking and savings accounts (except those offered by credit unions). If you open a checking or savings account in this country, the firm offering you the account could be operating under the regulatory authority of the Fed, the OCC, the OTS, or it could be an account at a state-chartered bank that has no federal oversight. Moreover, the regulator of your bank is not assigned randomly—firms choose the charter they want, which means they effectively can shop for the regulator they view as most appealing. Frequently, they choose the regulator they believe is the most incompetent and therefore the least likely to exercise any authority. Since its inception in the late 1980s, that regulator has consistently been the OTS. Among the many sweeping changes in the proposed plan of reform is the intent to eliminate the OTS.  If no other part of the plan is passed, this part should be.

(more…)

Tags: Economic Crisis, Finance, Helwege, Politics
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Bank Detox Halted

Thursday, June 4th, 2009

“The Federal Deposit Insurance Corporation indefinitely postponed a central element of the Obama administration’s bank rescue plan on Wednesday, acknowledging that it could not persuade enough banks to sell off their bad assets,” according to The New York Times. The Times reports that the cancellation confirmed many oberservers’ suspicions that the program may not work.

Among those skeptical of the plan at the outset was Smeal’s Jean Helwege, who wrote for Business Casual in March that the plan’s success depended on how well the Obama administration pressured the banks into writedowns.

From Helwege’s March 26 entry:

A critical part of the Treasury plan to remove the toxic assets is participation by the banks.  One has to wonder why these assets, which have been weighing them down for well over a year, have not yet been sold. One potential problem is a lack of liquidity: Few financial institutions have the funds available to buy them. Thus the Treasury has moved to provide financing in its auction. However, another possibility is that banks are reluctant to sell the assets. Bank regulations provide perverse incentives to troubled banks: Even when the banks and the market know the true value of a bad loan, banks resist writing down their assets to avoid having to raise more capital to secure deposits.

As long as few toxic assets are trading, bank regulators cannot easily prove that banks are operating with faulty balance sheets. Suppose a bank makes a $100 loan that subsequently goes bad. If the bank reappraises the loan at $60, it must find an additional $40 in capital to maintain its regulatory net worth. As bad as that sounds, a Treasury-sponsored auction that reveals a value of only $30 would be even worse, as it might indicate insolvency and thus lead regulators to take over the bank. Some banks would rather not participate in any plan to clean up toxic assets if the asset values they record in their books are still far from the true market values.  Instead, they will prefer to wait for recovery, no matter how slow.

Whether the plan works or not depends crucially on banks’ incentives to participate, and this in turn depends crucially on how well bank regulators have succeeded in pressuring banks to write down assets to reflect the true losses. Treasury efforts to entice buyers with subsidies and loan guarantees will help bring them to the auctions, but their profits from buying cheap toxic loans will not materialize if the banks stay away. As infuriating as these subsidies are to American taxpayers, things could be worse if banks refused to cough up the assets on which Wall Street vultures hope to profit.

Tags: Banking, Economic Crisis, Finance, Helwege
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New Derivatives Regulations

Friday, May 15th, 2009

The Obama Administration on Wednesday announced a proposal to regulate the credit derivatives market as part of an effort to avoid another financial crisis.  According to Smeal’s Jean Helwege, “The lynchpin of the plan is the requirement that all credit default swaps (CDS) contracts trade on a regulated exchange so that they involve a reasonable amount of capital and to increase the transparency of the market.”

But, Helwege says, “The plan to require a CDS exchange misses the crux of the crisis, as it does almost nothing to reform the current setup.” She says the country would be better served by focusing reforms in the mortgage market, specifically targeting Fannie Mae and Freddie Mac.

More from Helwege:

The motivation for this reform is the failure of the giant insurance company, A.I.G., which became financially distressed as a result of writing hundreds of billions of CDS contracts (essentially offering insurance on bonds). 

The plan to require a CDS exchange misses the crux of the crisis, as it does almost nothing to reform the current setup.  If the requirement is extremely onerous to Wall Street, the CDS as we know it will cease to exist and the bankers will invent a new contract that evades the regulations but includes the essence of a CDS contract.  If the regulation is not onerous, the CDS will start to trade on the exchange and two changes will occur that President Obama believes are very important. 

First, the trades will be written down in a central place so that regulators can observe the depth of the market and understand the prices involved in these transactions.  While this sounds like a major innovation, regulators can and do buy data on the CDS market from a vendor whose coverage is quite comprehensive. 

Second, the CDS exchange will require that sellers maintain a margin account and put up more cash as the CDS premium increases.  The market already requires that CDS sellers put up more cash as bond default probabilities increase. Indeed, this is the source of AIG’s cash crunch—their trading partners were requiring more and more collateral as the economy collapsed and corporate bond prices declined.  Putting this requirement into writing as part of a CDS exchange would not have made AIG more or less vulnerable to losses surrounding CDS contracts.

(more…)

Tags: Economic Crisis, Finance, Helwege, Politics
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Stress(less) Tests

Monday, May 4th, 2009

The Obama administration on Thursday will release the results of its bank stress tests, which the administration hopes will show that “the broad financial system is healthier than many investors fear,” according to The New York Times.

But Smeal’s Edward Ketz, is not that enthusiastic about the value of these stress tests. “Banks are undercapitalized in the U.S. and no amount of propaganda will change that essential truth,” he writes in a recent column on SmartPros.com.

Ketz examined the stress test methodology and calls a few aspects of it “puzzling.” Specifically, he has concerns about how the tests account for the banks’ intangibles, deferred tax assets, and preferred stock.

“One begins to wonder whether the purpose of these stress tests is really to evaluate the well-being of banks during hard times or whether it serves a more political purpose when regulators try to get as many banks as possible to pass these stress tests,” he writes. “Somebody is going to have to improve the accounting and give an exam that banks might actually fail in a highly public fashion before the markets will be pacified.”

Tags: Accounting, Banking, Economic Crisis, Finance, Ketz
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