Alternate scenarios for post-Sept. 15 2008

[cheesehead]

What _should_ the U.S. government have done following September 15, 2008 and what might be the different consequences now?

I want as much thoughtful realism as possible, not glib slams at the Fed, Prez, Congress, political parties and ideologies. I'm looking for the construction of realistic scenarios, with thought for the minuses as well as pluses of alternatives to what was actually done.

Perhaps we could have a few scenarios postulating different September 2008 actions, then explore the differing consequences.

Again, I want sincere thoughts, not just "Oh, we'd be hunky-dory now". We would still have a mess, but it could be a somewhat different and marginally better mess.

[cheesehead]

Bump

[ewmayer]

I've composed a first-draft post summarizing my thoughts on the matter, will post a reply tomorrow, after sleeping on it. Many of my thoughts on the matter are (or should be) familiar to regular readers of the MET2010 thread.

[ewmayer]

OK, here's my first cut...

Given that much-needed resolution authority for nonbank financial firms (NBFF) was not (and still is not) in place, the alternatives to government bailouts were effectively two-fold:

[1]bankruptcy (Lehman-style), and

[2] forced sale to a private entity (e.g. the sale of Bear Stearns to JP Morgan, although the government backstopped the risk there by taking most of Bear`s toxic assets onto its books by way of the first of the Fed`s dubiously legal "Maiden Lane" holding facilities).

As we saw post-Lehman, disorderly bankruptcy of a large NBFF - especially one which has been allowed to leverage up to a ridiculous degree (thanks to then-Goldman-head Hank Paulson`s famous mid-90s lobbying of the government to permit a set of designated firms to lever thusly) - can be extraordinarily messy, and at least in the short run, highly damaging to the capital and credit markets.

Given that the underlying problem - too much bad debt riddling the system - can ultimately only be solved by marking said debt to market and making someone incur the resulting hit to their balance sheet - how to do this without triggering financial Armageddon? Note that it`s by no means clear that we have in fact avoided financial Armageddon, since most of the toxic debt at the root of the crisis remains unwritten-down and silently continues to fester and impair banks balance sheets, but it`s clear that it was kept from occurring at the time.

So here are some suggestions for what should have (and should not have) been done - I divide these into 2 categories, "Mitigating the crisis" and "Preventing the next crisis":

1. Mitigating the crisis:

o When a NBFF goes under and some kind of temporary government backstop is needed to prevent chaos, do NOT reward the firm`s bondholders by paying them off at par, AIG-takeunder-style, DO remove all the firm`s senior management, DO wipe out the common shareholders, and DO attempt to claw back any bonuses management gave themselves while running the firm into the ground.

o Do NOT allow the use of the U.S. Treasury and the Fed as giant taxpayer-funded slush funds to buy up bad assets at deliberately overpriced valuations in a vain attempt to keep the original bubble inflated.

o DO allow the use of temporary government liquidity facilities to support the (relatively small) portion of the capital markets crucial to the real productive economy (e.g. lending to small businesses), Note that despite the massive government liquidity support to the TBTFs, very little of that lending capacity has found its way into the real economy in any kind of productive-use form.

o Make funds available (as the govt is doing) for extended unemployment compensation, BUT instead of just giving the money away, make those beneficiaries (who are able) DO SOME KIND OF SEMI-USEFUL WORK FOR THE MONEY, even if it is "menial" or "demeaning" work like cleaning up local parks, streets and city facilities. In other words, DO provide an extended safety net,but do NOT encourage folks to leech off the system for years on end.

2. Preventing the next crisis:

o Do NOT encourage too-big-to-fail financial firms (TBTFs) to become even bigger as a result of swallowing their troubled brethren ... too big to fail means too big to exist – one must instead break up the TBTFs.

o DO reinstate Glass-Steagall;

o Force all derivatives trading to conform to standardized structuring rules (a la standardized options) and to be conducted transparently on public exchanges;

o Require all parties in the debt-securitization food chain to "maintain some skin in the game". To prevent cherry-picking with respect to what they sell and what they hang on to, they must retain some minimum fraction of every securitized asset they sell. (Note this fraction would automatically impose one kind of leverage limit.)

o Restore reasonable limits on leverage, and make sure they apply to unencumbered, fairly-valued capital assets, i.e. ones marked-to-market rather than using the firms` own in-house mark-to-myth models. (This also includes banning off-balance-sheet accounting gimmicks).

o Phase out the "special status" of Fannie and Freddie, which includes requiring them to adhere to the same more-sane leverage limits above. (Fan and Fred had peak housing-insanity leverage approaching 100-to-1, which is just nuts).

o Aggressively pursue and prosecute the major actors in the whole fraud-laced securitization feeding chain, from the writers (and yes, even the takers-out of) fraudulent mortgages, to the givers of fraudulent-appraisals-for-pay, to the firms that bundled said mortgages without looking closely at their provenance (or even went to great lengths to disguise same), to the government-sanctioned ratings cartel which bestowed fraudulent AAA blessings on the securitized garbage, to the financial firms which sold the stuff all over the world. Bear in mind that to date, there has not been a single prosecution of *anyone* involved in this debacle. (We hope the recently-announced Goldman Sachs inquiry will be the first of many, but we fear that it is mostly for show, a juicy bit of political-financial theater of distraction)

o Stop making it government policy to encourage insane levels of leverage (i.e. debt) in the financial markets and the private-credit sphere, and STOP ENCOURAGING THE BLOWING OF SPECULATIVE ASSET BUBBLES! The government's only useful role is to set policies and regulations which are supportive of market transparency and sustainable economic growth. That aim of sustainability requires everyone (both the public and private sectors) to learn to live within their means. Given the massive level of accrued debt in the system currently, there is alas no way back to sustainable economic growth which does not involve a painful and possibly protracted bout of deleveraging. That is the unfortunate mathematical reality the Keynesian Ponzi artists are attempting to deny and circumvent. But it won`t work because it can`t work - you cannot cure a crisis of solvency by playing shell games with debt. At best this simply delays the inevitable day of reckoning. At worst - and the Greenspan-led-Fed`s disastrous attempt to mitigate the implosion of one asset bubble (the one related to the dotcom mania) by blowing an even bigger, much-more-destructive one in real estate is the textbook example of this - you make the eventual reckoning much worse by way of such extend-and-pretend and bail-rather-than-let-fail strategies.

[R.D. Silverman]

Originally Posted by ewmayer

OK, here's my first cut...
[snip]

Give back control of companies to stockholders by making it mandatory
that all salary plans/bonuses be approved by majority vote at the annual
stockholders meeting.

Only allow *salary* as corporate compensation.

The purpose of these requirements is to make it less attractive for
employees to indulge in short-term high risk behaviors. Current
compensation schemes promote such behavior.

[smh]

Is it really necessary to quote a full post?

[ewmayer]

Looks like there may be promising developments on the toxic-mortgage and ratings-agency fronts:

Senate votes to ban liar loans: The Senate voted Wednesday to ban controversial "liar loans," which helped bring down the housing market.

The legislation, part of the broader financial regulatory reform bill working its way through Congress, would require lenders to fully document a borrower's income before originating a mortgage. It would also mandate that lenders verify a borrower's ability to repay the loan.

My Comment: What - you expect lenders to do your dirty work for you and actually check whether would-be borrowers are in a position to service the debt? How dare you interfere with Americans` constitutional right to own a home. What next - ya gonna attach conditions to our constitutional right to be happy, well-fed and working (but not too hard) at a good-paying job with generous health and retirement benefits? Don`t you dare go oppressing me with your "underwriting standards" and arbitrary,subjective, politically motivated "ability to service the debt" judgments. Bloody debt Nazis...


Senate Passes Proposal to Create Ratings Board for Asset-Backed Securities: The U.S. Senate approved a proposal to let regulators decide who rates asset-backed securities after investors said Standard & Poor’s and Moody’s Investors Service assigned inflated assessments to mortgage bonds because the companies were paid by Wall Street firms selling the debt.

“There is a staggering conflict of interest affecting the credit-rating industry,” said Senator Al Franken, a Minnesota Democrat who offered the amendment. “Issuers of securities are paying for the credit ratings. They shop around for their ratings.”

Public pension funds blame S&P, Moody’s and Fitch Ratings for helping cause the global financial crisis by giving top rankings to mortgage-linked securities that blew up when the housing market collapsed in 2007. Lawmakers and regulators have been debating for three years how to reduce conflicts at the companies.

Under Franken’s amendment, the SEC would determine the size of the board. The majority of members would be investors, at least one member would be from a credit-rating company and at least one member would be from an investment bank.

My Comment: A reasonable proposal ... but only long-term useful if the regulators actually DO THEIR JOBS,in stark contrast to most of the past decade. There is also the question of how to rate the ratings agencies in terms of their performance ... do we need another ratings agency for that? (It seems Franken intends the board to do this job, but how best to avoid conflicts of interest,long-term-relationship cronyism and regulatory capture there?)

[cheesehead]

Originally Posted by ewmayer

OK, here's my first cut...

Thank you.

I'd not yet seen as comprehensive a scenario elsewhere (I'd seen some smaller itemized lists) ... but as I said, that may just show that I'm not hanging out in the right neighborhoods.

Yours looks like the sort of outline I seek.

As we saw post-Lehman, disorderly bankruptcy of a large NBFF - especially one which has been allowed to leverage up to a ridiculous degree (thanks to then-Goldman-head Hank Paulson`s famous mid-90s lobbying of the government to permit a set of designated firms to lever thusly) - can be extraordinarily messy, and at least in the short run, highly damaging to the capital and credit markets.

I'd like to see some more detail, and numerical estimates, of how the course of damage would've likely run in the bankruptcy case. Let me clarify that I'm not asking you, Ernst, to provide that. My basic problem here is that I don't have education or experience for being able to construct realistic details of the sort I seek. I'm quite willing to simply follow some links.

Why don't I just start googling for that? Because it's too far down my list, and first attempts found nothing. Yes, I do find plenty of conservatives explaining what they'd like to see done in our real future. What I haven't found is conservatives explaining just how their proposed alternative actions starting on September 15, 2008 would've worked out to cause less damage than we actually have had.

1. Mitigating the crisis:

o When a NBFF goes under and some kind of temporary government backstop is needed to prevent chaos, do NOT reward the firm`s bondholders by paying them off at par, AIG-takeunder-style, DO remove all the firm`s senior management, DO wipe out the common shareholders, and DO attempt to claw back any bonuses management gave themselves while running the firm into the ground.

I'm wondering (but, again, not actually asking you, Ernst, to answer) how we could have arrived at a situation in which all those rules would have been followed in September 2008 and later.

That is, what pressures were on the various decision-makers to skimp on, or avoid, those rules, and how could those pressures have been prevented from influencing those decision-makers? A general answer is "reduce the baleful influence of Wall Street". Yes, but how could that theoretically have been accomplished by Sept. 15, 2008 -- outside a Tom Clancy novel, that is.

o Do NOT encourage too-big-to-fail financial firms (TBTFs) to become even bigger as a result of swallowing their troubled brethren ... too big to fail means too big to exist – one must instead break up the TBTFs.

Consider the generalized problem of business mergers creating firms big enough to tend toward either monopolism, excessive single influence on the economy, or some other too-big problem.

One proposal I've seen is to make corporate income tax rates slightly progressive -- raise them slightly on the high end, lower them slightly on the low end, or both -- so as not to unduly burden mergers that accomplish genuine efficiencies of scale, but discourage large mergers having no real efficiency-of-scale basis.

[Andi47]

Originally Posted by ewmayer

o Stop making it government policy to encourage insane levels of leverage (i.e. debt) in the financial markets and the private-credit sphere, and STOP ENCOURAGING THE BLOWING OF SPECULATIVE ASSET BUBBLES!

I think that's the most important point - and STOP INSCRUTABLE AND TOXIC BONDS!!!

I mean... there are Futures, and I think I understand what they are and that they are necessary under certain circumstances (e.g. an oil refinery pays $$*x to get a delivery of x barrels of crude by Monday next week, or a sugar refinery pays $$ for delivery of xy hectares worth of sugar beets by autumn), but WHAT THE H*LL are (and WHAT FOR ARE) "Knock out certificates", "Open end Knock out certificates", "capped reverse bonus certificates" and such??

BTW: Discouraging bubbles of speculative assets: What about tax on speculative assets (or: profit made of those) which makes it difficult (or nearly impossible) to make more profit than one pays for loan interests? (e.g. if the usual-in-the-market loan interest is 5%, and one makes a profit of 5+x% by buying and selling speculative bonds, collect x% as a tax)

[apocalypse]

Originally Posted by Andi47

BTW: Discouraging bubbles of speculative assets: What about tax on speculative assets (or: profit made of those) which makes it difficult (or nearly impossible) to make more profit than one pays for loan interests? (e.g. if the usual-in-the-market loan interest is 5%, and one makes a profit of 5+x% by buying and selling speculative bonds, collect x% as a tax)

Heck. Just eliminate the tax-deductibility of the interest. Using margin to gain leverage shouldn't be considered a normal business expense.

[cheesehead]

This article, "Larry Summers' Contradictory and Dishonest Defense of Administration's Bank-Focused Crisis Response" has the best explanations in one place that I've yet seen.

(I'm not claiming that no earlier article was as good or better -- I'm not a comprehensive reader of financial media. But Ernst's third link in his post #51 in the MET2014 thread led me to this one.)