Gillian Tett has written an interesting book about CDS and CDOs – Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe (Free Press: 2009). According to the book, in the early 1990s, J.P. Morgan was looking for ways to lower its capital requirements under the Basel I Accord of 1988. The risk weight on what it considered high quality loans was 100%, meaning that there was an 8% capital requirement on such loans. J.P. Morgan went to the OCC and the Fed to see if they could convince these regulators that, if the credit risk was off-loaded through credit derivatives, reduced capital requirements should apply. (See Fool’s Gold, pp. 45-49.)
On August 12, 1996, the Fed issued a “Supervisory Guidance for Credit Derivatives” which indicated that banks could lower their capital requirements through CDS to the risk category of the guarantor. In the case of another bank, the risk weight would be 20%.
When it came to synthetic CDS structures issued by an off-balance sheet entity, the bank retained what came to be called “super senior risk.” Initially the Fed said that to get capital relief on these transactions, banks would have to get rid of this risk (Fool’s Gold, p. 61). J.P. Morgan decided that the perfect counterparty for this was AIG Financial Products (Ibid., p. 62). Then, according to Tett, the OCC and the Fed decided that super senior risk need not be off loaded.
Apparently, though, the regulators in Europe did not see it that way. According to AIG’s March 2009 10-K filing –
“A total of $234.4 billion (consisting of corporate loans and prime residential mortgages) in net notional exposure of AIGFP’s super senior credit default swap portfolio as of December 31, 2008 represented derivatives written for financial institutions, principally in Europe, for the purpose of providing regulatory capital relief rather than for arbitrage purposes. These transactions were entered into by Banque AIG, AIGFP’s French regulated bank subsidiary, and written on diversified pools of residential mortgages and corporate loans (made to both large corporations and small to medium sized enterprises). In exchange for a periodic fee, the counterparties receive credit protection with respect to diversified loan portfolios they own, thus reducing their minimum capital requirements.
“The regulatory benefit of these transactions for AIGFP’s financial institution counterparties is generally derived from the terms of the Capital Accord of the Basel Committee on Banking Supervision (Basel I) that existed through the end of 2007 and which is in the process of being replaced by the Revised Framework for the International Convergence of Capital Measurement and Capital Standards issued by the Basel Committee on Banking Supervision (Basel II). Prior to the adoption of Basel II, a financial institution was required to hold capital against its assets, based on the categorization of the issuer or guarantor of the assets. One of the means for a financial institution to reduce its required regulatory capital was to purchase credit protection on a group of its assets from a regulated financial institution, such as Banque AIG, in order to benefit from such regulated financial institution’s lower risk weighting (e.g., 20 percent vs. 100 percent) that is assigned to those assets under Basel I. A lower risk weighting reduces the amount of capital a financial institution is required to hold against such assets.”
(I was directed to this by a blog post of Arnold Kling.)
Interestingly, as Basel II is implemented, this capital benefit is reduced. The 10-K goes on to say:
“Unlike Basel I, Basel II gives credit to the relative risk of loss associated with the assets, meaning that less capital is required for such assets. After a financial institution has implemented a capital model that is compliant with Basel II and has obtained approval from its local regulator, the CDS transactions provide no additional regulatory benefit in most cases, except during a transition period. The Basel II implementation includes a transition period during which the financial institutions must calculate their capital requirements under both Basel I and Basel II (until December 31, 2009). During this period, the capital required is “floored” at a percentage of the Basel I capital calculation; therefore, until early 2010, these CDS transactions may still provide regulatory capital benefit for AIGFP’s counterparties, depending on each counterparty’s particular circumstances. In addition, in a limited number of instances, counterparties may decide to hold these CDSs for a longer period of time because they provide a regulatory capital benefit, while smaller, under Basel II.”
Regulators both here and abroad seem to have not realized the systemic risk their regulations were creating. Risk got concentrated at AIG and, with respect to super senior risk, some U.S. banks retained it and when the real estate bubble burst, it turned out that this super senior risk was more risky than assumed. CDS and CDOs served not to diversify risk, as regulators, most prominently Greenspan asserted, but concentrated it. (According to Fool’s Gold, J.P. Morgan did not retain much super senior risk. Her book relies heavily on J.P. Morgan sources, which does not mean it is wrong, but could mean that it is less critical of that bank than other writers, with other perspectives, might have been. For those interested in these issues, the book is well worth reading.)
Now that the House has passed the health care legislation, it is likely that there will be more Administration, Congressional, and press attention to financial regulatory reform. It is clear that there were regulatory failures that contributed to the financial crisis (which does not mean that private sector actors do not shoulder a considerable amount of responsibility.) While there should be some sort of regulatory reform, it should be kept in mind that there are limits to what regulation can do. Regulators can make mistakes. One can hope that whatever becomes law makes things safer but that does not create a false sense of security and complacency.
Monday, March 22, 2010
Tuesday, March 2, 2010
Housing Bubble or Derivatives Inferno -- Comments on Gensler's FT Article
Last week the Financial Times published an article by CFTC Chairman Gary Gensler – “How We Can Stop Another Derivatives Inferno.” The article compares the 2008 financial crisis to the 1871 Great Chicago fire, which legend has it was started when Mrs. O’Leary’s cow kicked over a lantern, though the real cause remains a mystery. With respect to current events, Gensler writes: “In the autumn of 2008, certain financial institutions kicked over the lantern that set off the financial crisis – a fire that nearly burned down the global economy.”
As one might expect given his current position, Gensler’s article concentrates on derivatives. Still, it is remarkable that an article about the financial crisis does not mention the housing bubble, subprime mortgages, or securitization.
One of the underlying questions about the financial crisis, on which there is not much, if any serious analysis, is what role the OTC derivatives market played. The financial crisis is marked by a housing bubble which finally bursted. Did OTC derivatives help create that housing bubble by enabling financial intermediaries to take on more leverage? Once the housing bubble burst, did OTC derivatives make things worse?
The causes of the housing bubble will be debated for some time. There will be discussions about the role of loose monetary policy, lax regulation, the madness of crowds, government policies designed to encourage home ownership, Fannie Mae and Freddie Mac, securitization, capital rules, rating agencies, etc.
The clear evidence that OTC derivatives made things worse was the AIG debacle. Gensler focuses on that and also mentions the efforts to mask Greece’s true fiscal situation. His remedies are to regulate OTC derivatives dealers directly and to require standardized OTC derivatives to trade on exchanges and to be submitted to clearinghouses.
While a good case can be made for these recommendations, many of the derivatives that AIG was engaged in would most likely not be viewed as “standardized,” since they were on particular CDOs, which have been identified by CUSIP number and counterparty in a document now publicly available. Also, all the parties, including AIG were subject to regulation, either here or abroad. While it is not surprising that the Office of Thrift Supervision was unable effectively to supervise AIG as its holding company regulator, other regulators had tools at their disposal to curtail the growing exposure of regulated entities to AIG if they had become concerned. In any case, the exchange and clearing house recommendations seem to have little bearing on the AIG situation, nor apparently on what Greece and its financial institution counterparties may have arranged.
If AIG had been subject to regulation as an OTC derivatives dealer, this particular aspect of the financial crisis might have been prevented if its regulator had seen the problem. But would that have prevented the housing bubble and its bursting? While financial bubbles are probably inevitable, a better diagnosis of the causes of the financial crisis and an analysis of its effects is needed before anyone says they have definitively figured out how to prevent such large bubbles from forming and mitigating the damage of the bubbles that do form when they burst.
Finally, I am not sure what lantern it is that Gensler thinks financial institutions “kicked over” in 2008. I would use a metaphor. The subprime mortgage problems served as the catalyst setting off the crisis by acting to burst the housing bubble, which in turn created a host of other problems.
Dodd-Corker: The CFPA, the Treasury, and the Fed
The news this morning that Senators Dodd and Corker may agree on making the proposed Consumer Financial Protection Agency a division of the Federal Reserve rather than the Treasury Department, as Dodd had offered, reminds me of the 1986 jurisdictional questions concerning government securities regulation.
In 1986, after some severe problems in the government securities repo market, especially the failure of ESM, an unregulated government securities dealer in Florida, and the consequent turmoil for the state-insured thrifts in Ohio, it was clear that heretofore unregulated government securities brokers and dealers would be subject to regulation. The Treasury had resisted this in the past, but it dropped that opposition in the face of continuing problems in the government securities market and the political inevitability that Congress would act. The questions that remained were how much regulatory authority would be granted to a government agency in this area and the identity of that agency.
As to the second question, the identity of the agency, the SEC had quickly been written off as a candidate to write rules in this area, partly because of Administration opposition. The two remaining candidates were the Fed and the Treasury. The Congress and some market participants were leaning to the Fed as the preferred regulator. The arguments were similar to those probably being made today about were to house consumer financial protection if it is not entrusted to a new, “independent” agency.
It was pointed out that Treasury’s leadership was less stable than the Fed and that it is a more political agency. The Treasury argued in response that it had responsibility for debt management and that it was, therefore, in the best position to assume this responsibility. Moreover, the Treasury argued that there was no conflict in managing the public debt and regulating the dealers, because a market that was characterized by integrity would be best for minimizing interest costs on the government’s debt. A market that was characterized by fraud, on the other hand, would shrink scare potential investors away and result in higher interest costs.
Fortunately, for the institutional interests of the Treasury, Secretary James Baker was an excellent politician and negotiator, and Treasury ended up with the rulemaking authority. The Treasury has by all accounts done a good job of handling its responsibilities under the Government Securities Act of 1986.
Part of the reason that the Treasury did a good job in writing rules was due to the quality of the political leadership in Domestic Finance during the Reagan Administration. While that Administration generally had a deregulatory bent, the attitude at Treasury was that, since the Government Securities Act had been enacted, was the law, and Treasury had argued for getting this new authority, the Treasury was going to do as good a job as possible in carrying it out. In fact, the Congress had given very tight deadlines for putting out proposed, temporary, and final rules, and we met every deadline to the day.
Of course, there is no assurance that political staff at Treasury will always be good, just as there is no assurance that the Fed and its powerful staff will always make the correct judgments. One of the tradeoffs, of course, is that while there is less institutional continuity at Treasury, there is also less danger that mistaken judgments will persists for years.
As to the current question, I find it hard to see why those who think the Fed failed in its consumer protection role would want to give the Fed even more authority, even if a mechanism can be devised to give the new division some independence from the Board. As for the Treasury, a bureau might work, but if it had the independence of an OCC or OTS, there is little difference between that and an independent agency. Given the amount of staff necessary to do this right and the lack of any connection to what the Departmental Offices do, putting this authority there would likely not work very well.
As a final point, if staffed with the right people, any structure would likely work; if staffed with the wrong people, the organizational structure will not matter. If Congress creates something, the first years of a new consumer finance protection agency, bureau, or division will be extremely important.
In 1986, after some severe problems in the government securities repo market, especially the failure of ESM, an unregulated government securities dealer in Florida, and the consequent turmoil for the state-insured thrifts in Ohio, it was clear that heretofore unregulated government securities brokers and dealers would be subject to regulation. The Treasury had resisted this in the past, but it dropped that opposition in the face of continuing problems in the government securities market and the political inevitability that Congress would act. The questions that remained were how much regulatory authority would be granted to a government agency in this area and the identity of that agency.
As to the second question, the identity of the agency, the SEC had quickly been written off as a candidate to write rules in this area, partly because of Administration opposition. The two remaining candidates were the Fed and the Treasury. The Congress and some market participants were leaning to the Fed as the preferred regulator. The arguments were similar to those probably being made today about were to house consumer financial protection if it is not entrusted to a new, “independent” agency.
It was pointed out that Treasury’s leadership was less stable than the Fed and that it is a more political agency. The Treasury argued in response that it had responsibility for debt management and that it was, therefore, in the best position to assume this responsibility. Moreover, the Treasury argued that there was no conflict in managing the public debt and regulating the dealers, because a market that was characterized by integrity would be best for minimizing interest costs on the government’s debt. A market that was characterized by fraud, on the other hand, would shrink scare potential investors away and result in higher interest costs.
Fortunately, for the institutional interests of the Treasury, Secretary James Baker was an excellent politician and negotiator, and Treasury ended up with the rulemaking authority. The Treasury has by all accounts done a good job of handling its responsibilities under the Government Securities Act of 1986.
Part of the reason that the Treasury did a good job in writing rules was due to the quality of the political leadership in Domestic Finance during the Reagan Administration. While that Administration generally had a deregulatory bent, the attitude at Treasury was that, since the Government Securities Act had been enacted, was the law, and Treasury had argued for getting this new authority, the Treasury was going to do as good a job as possible in carrying it out. In fact, the Congress had given very tight deadlines for putting out proposed, temporary, and final rules, and we met every deadline to the day.
Of course, there is no assurance that political staff at Treasury will always be good, just as there is no assurance that the Fed and its powerful staff will always make the correct judgments. One of the tradeoffs, of course, is that while there is less institutional continuity at Treasury, there is also less danger that mistaken judgments will persists for years.
As to the current question, I find it hard to see why those who think the Fed failed in its consumer protection role would want to give the Fed even more authority, even if a mechanism can be devised to give the new division some independence from the Board. As for the Treasury, a bureau might work, but if it had the independence of an OCC or OTS, there is little difference between that and an independent agency. Given the amount of staff necessary to do this right and the lack of any connection to what the Departmental Offices do, putting this authority there would likely not work very well.
As a final point, if staffed with the right people, any structure would likely work; if staffed with the wrong people, the organizational structure will not matter. If Congress creates something, the first years of a new consumer finance protection agency, bureau, or division will be extremely important.
Wednesday, February 24, 2010
Quantitative Unease: The Treasury Assists the Fed in Conducting Monetary Policy
Yesterday the Treasury announced that it would begin auctioning, starting today, $200 billion of Treasury bills in eight weekly auctions. The proceeds are to be put in a special account at the Fed, the Supplementary Financing Account. This is a signal, in addition to the recent discount rate increase, that the Fed is beginning to tighten. What is unusual is that the signal came in the form of a low key Treasury press release.
The Treasury bills being issued pursuant to this program add to the supply of an outstanding issue, that is, the bills being sold at these special auctions have a maturity date that is the same as an outstanding bill issue and will consequently have the same CUSIP number as the outstanding bill issue. Once issued, there is no way to distinguish this addition to the supply of the outstanding bill to that which was previously issued.
The Treasury had let the supplementary financing account run down to $5 billion because of the debt limit. It says it is restoring it to the level it was at during much of last year.
The more important point is, as I have written before, the Treasury is undertaking these sales to help the Fed drain reserves from the banking system. In essence, rather than the Fed selling Treasury securities from its portfolio and thus draining reserves, the Treasury sells newly created securities and the proceeds are taken out of the banking system. The result on reserves is the same in either case.
Chairman Bernanke said last July that “although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.” The operational benefits of a little more reliance seems to outweigh for the time being the need to protect independence.
According to a Bloomberg News article today (not yet available online), the Fed is trying to downplay the significance of the Treasury announcement. The article by Rebecca Christie quotes the Fed: “‘The SFP is not a necessary element in the Federal Reserve’s set of tools to achieve an appropriate monetary policystance in the future,’ the Fed said. ‘Still, any amount outstanding under the SFP will result in a corresponding decrease in the quantity of reserves in the banking system,which could be helpful in the Federal Reserve's conduct of policy.’”
As I have commented in previous posts, there are policy and legal questions one can raise about the Supplementary Financing Program. The Treasury could also be criticized for paying interest for borrowing money it does not need. Fortunately for Treasury, short-term interest rates are quite low; the interest rate on the 56-day bill auctioned today was 0.1%. One can also explain that Fed alternatives would also cost the Treasury money. If the Fed sold securities from its portfolio, the Fed would receive less interest income and therefore would have less earnings to turn over to the Treasury. Alternatively, if the Fed raised the interest it pays on excess reserves held by banks pursuant to the authority it received in the TARP legislation, in order to encourage banks to hold idle balances, this would also reduce Fed earnings.
The Treasury also appears to be helping out the Fed in its cash management practices. It used to be that the Treasury would target a relatively small balance at the Fed, perhaps $5 billion or so, and keep the rest of its cash in commercial banks in what are called Treasury Tax and Loan Accounts (“TT&L”). A quick glance at Monday’s Daily Treasury Statement indicates that this is not the practice. On Monday, Treasury held $32.6 billion at its operating account at the Fed, $5 billion in the Supplementary Financing Program account, and $1.9 billion in TT&L accounts.
The Treasury bills being issued pursuant to this program add to the supply of an outstanding issue, that is, the bills being sold at these special auctions have a maturity date that is the same as an outstanding bill issue and will consequently have the same CUSIP number as the outstanding bill issue. Once issued, there is no way to distinguish this addition to the supply of the outstanding bill to that which was previously issued.
The Treasury had let the supplementary financing account run down to $5 billion because of the debt limit. It says it is restoring it to the level it was at during much of last year.
The more important point is, as I have written before, the Treasury is undertaking these sales to help the Fed drain reserves from the banking system. In essence, rather than the Fed selling Treasury securities from its portfolio and thus draining reserves, the Treasury sells newly created securities and the proceeds are taken out of the banking system. The result on reserves is the same in either case.
Chairman Bernanke said last July that “although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.” The operational benefits of a little more reliance seems to outweigh for the time being the need to protect independence.
According to a Bloomberg News article today (not yet available online), the Fed is trying to downplay the significance of the Treasury announcement. The article by Rebecca Christie quotes the Fed: “‘The SFP is not a necessary element in the Federal Reserve’s set of tools to achieve an appropriate monetary policystance in the future,’ the Fed said. ‘Still, any amount outstanding under the SFP will result in a corresponding decrease in the quantity of reserves in the banking system,which could be helpful in the Federal Reserve's conduct of policy.’”
As I have commented in previous posts, there are policy and legal questions one can raise about the Supplementary Financing Program. The Treasury could also be criticized for paying interest for borrowing money it does not need. Fortunately for Treasury, short-term interest rates are quite low; the interest rate on the 56-day bill auctioned today was 0.1%. One can also explain that Fed alternatives would also cost the Treasury money. If the Fed sold securities from its portfolio, the Fed would receive less interest income and therefore would have less earnings to turn over to the Treasury. Alternatively, if the Fed raised the interest it pays on excess reserves held by banks pursuant to the authority it received in the TARP legislation, in order to encourage banks to hold idle balances, this would also reduce Fed earnings.
The Treasury also appears to be helping out the Fed in its cash management practices. It used to be that the Treasury would target a relatively small balance at the Fed, perhaps $5 billion or so, and keep the rest of its cash in commercial banks in what are called Treasury Tax and Loan Accounts (“TT&L”). A quick glance at Monday’s Daily Treasury Statement indicates that this is not the practice. On Monday, Treasury held $32.6 billion at its operating account at the Fed, $5 billion in the Supplementary Financing Program account, and $1.9 billion in TT&L accounts.
Tuesday, February 23, 2010
AIG, FRBNY, Maiden Lane III, and Goldman Sachs
The attempt to figure out what happened in the AIG bailout continues. Bloomberg News has posted an article today on the subject -- "Secret AIG Document Shows Goldman Sachs Minted Most Toxic CDOs." This article is based on a document that the Federal Reserve Bank of New York ("FRBNY") did not want made public in unredacted form but was inserted into the record by Representative Darrell Issa (R, CA.), the ranking member of the U.S. House Committee on Oversight and Government Reform. The document, called "Schedule A," lists the credit default swaps ("CDS's") on collateralized debt obligations ("CDOs") that were put into an investment vehicle created by the FRBNY called Maiden Lane III (named after one of the streets bordering the FRBNY building in the Wall Street area).
Schedule A lists each underlying CDO by CUSIP number along with the tranche name, the associated AIG counterparty for the CDS on each CDO, the notional value (principle value of each CDO), the amount of collateral AIG had posted for each CDS, and the negative mark to market (difference between the market and notional value).
As explained in the written statement of Tom Baxter, the FRBNY's General Counsel, for a January 27 hearing of the House Oversight Committee, Maiden Lane III was funded by a $24.3 billion loan from the FRBNY, which is secured by CDOs AIG had insured with CDS contracts and a $5 billion equity investment from AIG. The purpose of Maiden Lane III was to terminate, or tear up, the CDS's sold to 16 AIG counterparties. In return for agreeing to tear up the contracts, the AIG counterparties were allowed to retain $35 billion in collateral which AIG had posted with them and to sell the underlying CDOs to Maiden Lane III. The $29.3 billion of funding was used to purchase the CDOs, which had a principal value of $62 billion. Mr. Baxter states that the fair market value of the CDOs was approximately $29.6 billion, and that therefore the counterparties essentially received "par" for the securities in return for tearing up the contracts.
Baxter's statement is somewhat vague about the exact amount the counterparties received from Maiden Lane III for the CDOs. According to a November 2009 report of the Special Inspector General for the Troubled Asset Relief Program ("SIGTARP"), Maiden Lane III paid the counterparties $27.1 billion and AIG Financial Products $2.5 billion as "an adjustment payment to reflect overcollateralization." (Page 5 of the report.) This adds up to $29.6 billion, the deemed fair value of the CDOs. Left unexplained is how Maiden Lane III was able to make payments of $29.6 billion, when its initial funding amounted to $29.3 billion.
Baxter also states that AIG's $5 billion equity investment is subordinated to the FRBNY's $24.3 billion loan and that the FRBNY, in addition to this downside protection, will get two-thirds of any profits Maiden Lane III makes. Maiden Lane III can hold the CDOs to maturity.
This seems like a pretty sweet deal for the counterparties for getting out of their exposures to both the CDOs they held and to AIG if the CDOs were to suffer a credit event that triggered a payment on the CDS (which I am distinguishing from collateral posting). In defense of the arrangement, Baxter states "...if AIG defaulted, and even filed for bankruptcy protection, the counterparties would have kept both the collateral and the underlying CDOs (and would have been made whole if they had sold the CDOs for fair value." [Emphasis in original.] However, this particular argument does not square with some of the Fed's justification for this transaction. If AIG had filed for bankruptcy, the "fair value" of the underlying CDOs would have gone down, perhaps substantially.
There will likely be more revelations about this matter as the press and official groups, such as the Financial Crisis Inquiry Commission and various Congressional committees, continue to investigate. In addition, as mentioned in a previous post, Goldman is a focus. This additional evidence that it was such a large counterparty to AIG, backed by some hard numbers, guarantees additional public scrutiny of the firm.
Tuesday, February 16, 2010
The Wages of Hubris (II) – Goldman Sachs(?)
Currently, Goldman Sachs is under intense scrutiny. Matt Taibbi’s article for the July 2 Rolling Stone, “Inside the Great American Bubble Machine,” in which he blames Goldman for market bubbles since the 1920s, is an extreme version of the criticism, which Goldman no doubt could effectively rebut if it felt it had to, but, depending on the facts which are not all known, more recent criticism involving AIG and now Greece might be harder to shake off.
During the 1980s, two of the most important investment banks had similar names but apparently quite different corporate cultures. They were, of course, Salomon Brothers and Goldman Sachs. Salomon was especially an important firm in the government securities market and I would note that its research department produced interesting papers, some of which, such as those having to do with the pricing of zero-coupon securities, I found very useful in my work for Treasury at the time. But Salomon's sense of its importance and invulnerability caught up with it when some of its officers thought they could get away with lying to the Treasury on the tender forms the firm submitted at auctions of Treasury securities. In 1991, they got caught, and the resulting scandal eventually led to the firm being merged with Smith Barney, and its name disappearing as part of Citigroup.
Goldman has never been as brazen in dealing with the government as Salomon. The firm makes great efforts to have good relationships with the government. As evidence of their success at this, the SEC has in the past directed other government agencies to Goldman for explanations of their state of the art compliance programs. It has also not hurt the firm’s reputation that many of its partners do a stint of government service and, whatever else one might want to say about these Goldman alumni, they are smart.
Goldman’s record is not unblemished, though. For example, on October 31, 2001, Goldman received word that Treasury had just announced that it would stop issuing 30-year bonds before the embargo on the news ended and traded on that information before it became generally know in the market. Goldman’s CEO, Henry M. Paulson, claimed that the firm had not violated SEC rules (“Goldman Chief Denies Firm Violated Any SEC Rule,” New York Times, April 6, 2002). However, the firm ended up settling with the SEC, disgorging $3.8 million in profits and $500,000 in interest and paying an additional $5 million penalty. Also, a Goldman employee was sentenced to almost three years in prison for his role in the affair.
This embarrassing history was, however, not mentioned when Paulson was later nominated and confirmed as Secretary of the Treasury. Everyone seemed relieved that a man with a successful Wall Street career was taking over Treasury after being headed by two Secretaries who had received generally bad reviews and had been viewed as ineffective. And however one might evaluate Secretary Paulson’s actions during the financial crisis, no one doubted his level of knowledge nor his influence in making policy.
Currently, as I have mentioned in a previous post, there are questions about Goldman’s relationship with AIG. The New York Times published an article about this a week ago, "Testy Conflict with Goldman Helped Push AIG to Edge." However justified Goldman’s demands for collateral were from a weakening AIG, Goldman had to know at some point that its demands were increasing the risk of an AIG bankruptcy, in the wake of which the entire market, including Goldman, would suffer. It appears we do not know the whole story here, and, as long as we do not, Goldman can expect there to be some suspicion directed its way.
Now it turns out that Goldman was helping out Greece in hiding its true fiscal situation through transactions Goldman arranged. Simon Johnson, a former chief economist of the IMF, has been especially critical of Goldman on this.
Given the threat to the euro of the Greek situation and what that means to the global monetary system, this affair could prove a challenge to Goldman. It is quite possible that Europe will be able to muddle through this problem and any future ones (Portugal, Ireland, Italy, Spain?), but the dangers are real. Of course, they are not Goldman’s fault; a reasonable argument is that Europe got too far ahead of itself in creating a single currency and that the UK was right to stay out. But Goldman’s facilitating hiding fiscal problems will be examined.
The people who run Goldman are smart, and they may be able to ride out their current problems. The facts, of course, may be more benign than one might now suspect. But their actions and their success in making huge profits are getting unprecedented scrutiny. They have much greater name recognition than they have ever had; for them, that is not a good thing.
During the 1980s, two of the most important investment banks had similar names but apparently quite different corporate cultures. They were, of course, Salomon Brothers and Goldman Sachs. Salomon was especially an important firm in the government securities market and I would note that its research department produced interesting papers, some of which, such as those having to do with the pricing of zero-coupon securities, I found very useful in my work for Treasury at the time. But Salomon's sense of its importance and invulnerability caught up with it when some of its officers thought they could get away with lying to the Treasury on the tender forms the firm submitted at auctions of Treasury securities. In 1991, they got caught, and the resulting scandal eventually led to the firm being merged with Smith Barney, and its name disappearing as part of Citigroup.
Goldman has never been as brazen in dealing with the government as Salomon. The firm makes great efforts to have good relationships with the government. As evidence of their success at this, the SEC has in the past directed other government agencies to Goldman for explanations of their state of the art compliance programs. It has also not hurt the firm’s reputation that many of its partners do a stint of government service and, whatever else one might want to say about these Goldman alumni, they are smart.
Goldman’s record is not unblemished, though. For example, on October 31, 2001, Goldman received word that Treasury had just announced that it would stop issuing 30-year bonds before the embargo on the news ended and traded on that information before it became generally know in the market. Goldman’s CEO, Henry M. Paulson, claimed that the firm had not violated SEC rules (“Goldman Chief Denies Firm Violated Any SEC Rule,” New York Times, April 6, 2002). However, the firm ended up settling with the SEC, disgorging $3.8 million in profits and $500,000 in interest and paying an additional $5 million penalty. Also, a Goldman employee was sentenced to almost three years in prison for his role in the affair.
This embarrassing history was, however, not mentioned when Paulson was later nominated and confirmed as Secretary of the Treasury. Everyone seemed relieved that a man with a successful Wall Street career was taking over Treasury after being headed by two Secretaries who had received generally bad reviews and had been viewed as ineffective. And however one might evaluate Secretary Paulson’s actions during the financial crisis, no one doubted his level of knowledge nor his influence in making policy.
Currently, as I have mentioned in a previous post, there are questions about Goldman’s relationship with AIG. The New York Times published an article about this a week ago, "Testy Conflict with Goldman Helped Push AIG to Edge." However justified Goldman’s demands for collateral were from a weakening AIG, Goldman had to know at some point that its demands were increasing the risk of an AIG bankruptcy, in the wake of which the entire market, including Goldman, would suffer. It appears we do not know the whole story here, and, as long as we do not, Goldman can expect there to be some suspicion directed its way.
Now it turns out that Goldman was helping out Greece in hiding its true fiscal situation through transactions Goldman arranged. Simon Johnson, a former chief economist of the IMF, has been especially critical of Goldman on this.
Given the threat to the euro of the Greek situation and what that means to the global monetary system, this affair could prove a challenge to Goldman. It is quite possible that Europe will be able to muddle through this problem and any future ones (Portugal, Ireland, Italy, Spain?), but the dangers are real. Of course, they are not Goldman’s fault; a reasonable argument is that Europe got too far ahead of itself in creating a single currency and that the UK was right to stay out. But Goldman’s facilitating hiding fiscal problems will be examined.
The people who run Goldman are smart, and they may be able to ride out their current problems. The facts, of course, may be more benign than one might now suspect. But their actions and their success in making huge profits are getting unprecedented scrutiny. They have much greater name recognition than they have ever had; for them, that is not a good thing.
The Wages of Hubris (I) – Fannie Mae and Freddie Mac
Scandals and crises are periodic occurrence in financial markets. Sometimes the arrogance of those involved is breathtaking. For example, who can fail to remember Enron or the accounting scandals of Fannie Mae and Freddie Mac?
With respect to the latter, Fannie and Freddie had successfully fought off Treasury’s attempts to rein them in over the years. The Treasury has had an institutional bias against Government Sponsored Enterprises (“GSEs”), of which Fannie and Freddie are the largest. The reason for this was once succinctly summarized to me by a senior career Treasury official – “They pay themselves private sector salaries but do not take private sector risks.”
At Treasury, we knew that no matter how loudly we proclaimed that the Treasury did not guarantee Fannie and Freddie securities, which was technically accurate, no one would believe us. Consequently, GSE securities, with somewhat higher yields than Treasuries, competed with Treasury securities. Treasury’s debt managers did not appreciate this.
When the firms were approaching failure and were put into conservatorship, market participants’ assessment of the value of the “implicit” guarantee proved accurate. The government had little choice. Even if it had been willing to make private investors in Fannie and Freddie debt suffer financial losses, it could not afford to do this to foreign central banks which had invested in Fannie and Freddie debt.
The creation of a new safety and soundness regulator in 1992 at Treasury’s urging, the Office of Federal Housing Enterprise (“OFHEO,” which was merged into the Federal Housing Finance Agency in 2008), did not faze these firms. In fact, the two mortgage giants took on more interest rate risk while under OFHEO’s supervision. For both GSEs at the time of OFHEO’s creation, the income from guarantee fees on their mortgage backed securities (“MBS”) was greater than the income from the interest rate spread on their portfolio holdings. During the years of OFHEO supervision, this relationship between the two types of income reversed, meaning that Fannie and Freddie were taking on interest rate risk as well as credit risk in order to increase their profits. (Ultimately, of course, the interest rate risk did not matter. Their recent fate was due to growing defaults.)
But in the late 90s and subsequent years, Fannie and Freddie apparently did not realize that the political landscape was changing. They had most of Wall Street intimidated by their size, but the relaxation of Glass-Steagall rules and then its repeal in 1999 allowed the big banks to get even larger. In 1999, some of these banks created an organization called “FM Watch.” They were concerned that Fannie and Freddie, in their attempt to maintain their historical returns on equity, which at times was around 30%, would continue to broaden their activities in direct competition with the banks. The market for conforming mortgages might not grow fast enough to suit the GSEs, and the banks wanted at a minimum to limit what Fannie and Freddie could do.
Both firms decided to adopt aggressive accounting policies which crossed the line of what was permissible. In Fannie’s case, the arrogance was remarkable; right up to the end in 2004, Frank Raines was testifying before a Congressional committee that he thought the accounting rules were complex but did not believe that Fannie had done anything wrong. (I was following this at Treasury, and, though I have forgotten the details, I remember thinking at the time that it was hardly a close question of whether Fannie had crossed over the line in its accounting.)
Mr. Raines insisted that the SEC review the conclusions of the more aggressive OFHEO he was then facing. One has to wonder what he was thinking. The SEC also thought Fannie had broken the rules, and by the end of 2004, Frank Raines had left Fannie Mae.
Currently, the knives seem to be out for yet another firm Goldman Sachs, though not, at least not yet, from the regulators. Goldman is the subject of the next post.
With respect to the latter, Fannie and Freddie had successfully fought off Treasury’s attempts to rein them in over the years. The Treasury has had an institutional bias against Government Sponsored Enterprises (“GSEs”), of which Fannie and Freddie are the largest. The reason for this was once succinctly summarized to me by a senior career Treasury official – “They pay themselves private sector salaries but do not take private sector risks.”
At Treasury, we knew that no matter how loudly we proclaimed that the Treasury did not guarantee Fannie and Freddie securities, which was technically accurate, no one would believe us. Consequently, GSE securities, with somewhat higher yields than Treasuries, competed with Treasury securities. Treasury’s debt managers did not appreciate this.
When the firms were approaching failure and were put into conservatorship, market participants’ assessment of the value of the “implicit” guarantee proved accurate. The government had little choice. Even if it had been willing to make private investors in Fannie and Freddie debt suffer financial losses, it could not afford to do this to foreign central banks which had invested in Fannie and Freddie debt.
The creation of a new safety and soundness regulator in 1992 at Treasury’s urging, the Office of Federal Housing Enterprise (“OFHEO,” which was merged into the Federal Housing Finance Agency in 2008), did not faze these firms. In fact, the two mortgage giants took on more interest rate risk while under OFHEO’s supervision. For both GSEs at the time of OFHEO’s creation, the income from guarantee fees on their mortgage backed securities (“MBS”) was greater than the income from the interest rate spread on their portfolio holdings. During the years of OFHEO supervision, this relationship between the two types of income reversed, meaning that Fannie and Freddie were taking on interest rate risk as well as credit risk in order to increase their profits. (Ultimately, of course, the interest rate risk did not matter. Their recent fate was due to growing defaults.)
But in the late 90s and subsequent years, Fannie and Freddie apparently did not realize that the political landscape was changing. They had most of Wall Street intimidated by their size, but the relaxation of Glass-Steagall rules and then its repeal in 1999 allowed the big banks to get even larger. In 1999, some of these banks created an organization called “FM Watch.” They were concerned that Fannie and Freddie, in their attempt to maintain their historical returns on equity, which at times was around 30%, would continue to broaden their activities in direct competition with the banks. The market for conforming mortgages might not grow fast enough to suit the GSEs, and the banks wanted at a minimum to limit what Fannie and Freddie could do.
Both firms decided to adopt aggressive accounting policies which crossed the line of what was permissible. In Fannie’s case, the arrogance was remarkable; right up to the end in 2004, Frank Raines was testifying before a Congressional committee that he thought the accounting rules were complex but did not believe that Fannie had done anything wrong. (I was following this at Treasury, and, though I have forgotten the details, I remember thinking at the time that it was hardly a close question of whether Fannie had crossed over the line in its accounting.)
Mr. Raines insisted that the SEC review the conclusions of the more aggressive OFHEO he was then facing. One has to wonder what he was thinking. The SEC also thought Fannie had broken the rules, and by the end of 2004, Frank Raines had left Fannie Mae.
Currently, the knives seem to be out for yet another firm Goldman Sachs, though not, at least not yet, from the regulators. Goldman is the subject of the next post.
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