Sunday, November 23, 2008

Time to change the rules

Barack Obama has time to consider how his administration will minister to the ailing auto companies, as their demise will be protracted. In the real economy, failure takes time. Sixty days from now GM will still be there.

But the same cannot be said of Citibank.

Today, after investing almost half of the $700 billion appropriated by Congress to buttress the capital reserves of the banking system, the evidence suggests that the Treasury and the Federal Reserve have not achieved their goal of easing the cost or availability of capital. Instead, the major banks are cutting back credit, increasing fees and looking for ways to further solidify their balance sheets. Unless these trends are reversed, the concerted federal action will have been for naught, the recession will deepen and recovery will be forestalled.

More capital alone is not sufficient to fix the commercial banking sector, and a new injection of funds into Citibank will not allay the fear the continues to grip the system. Like Citibank, all of the commercial banks have problem loans and problem business lines, and, traditionally, new injections of capital would provide banks with the resources necessary to work out those issues. But today, the risks are different, and more dire.

The collapse of AIG two months ago highlighted for all market participants the risks presented by derivative contracts on the books of financial institutions. AIG’s demise came in a matter of days––if not hours––once its credit ratings were downgraded from the double-A level to the single-A level. On Friday, September 13th, AIG was in business. On Monday the 15th, AIG was downgraded. On Tuesday the 16th, the global insurance giant was effectively bankrupt.

In the case of AIG, the rating downgrades resulted from write-downs in its holdings of mortgage-backed securities––to comply with mark-to-market accounting rules––which depleted its capital reserves. The downgrades triggered collateralization requirements under the terms of its $450 billion portfolio of credit default swaps. Faced with demands for collateral that exceeded its financial resources, AIG was insolvent.

The lesson for the major commercial banks that face similar risks was simple: Do everything in your power to rebuild your financial strength and stabilize your credit ratings. Cut back lending, reduce outstanding credit facilities, increase fees, conserve capital, and rebuild your balance sheets. In sum, the lesson for the commercial banks is that if you want to survive––if you don't want to be the next AIG––you should not do any of the things--such as increase lending--that the Treasury is trying to get you to do.

Today, Citibank is rated AA-, which by any measure is a strong credit rating. But the markets are anticipating Citibank’s demise. On Friday, Citibank shares fell 20% to $3.77 and its total market value fell to $20.5 billion, a decline of 90% from a year ago, and less than the $25 billion that the US government gave Citibank just last month. In the credit default swap market, the cost of insuring against a Citibank default rose 20% on Friday.

In normal times, a downgrade to A+ would not be a catastrophic event for a commercial bank, but these are not normal times. While there has been no public indication from Citibank of what the financial consequences of a credit rating downgrade to single-A would be, Citibank is currently the guarantor on $1.6 trillion of credit default swap contracts––almost four times the size of AIG’s portfolio––and it is not unreasonable to imagine that those contracts have comparable collateralization terms. If this is AIG all over again, a downgrade of Citibank’s ratings would lead to the swift collapse of what one year ago was the nation’s largest bank.

But this is not just about Citibank. Over the next several days, the Treasury may announce its plans to pour billions more into Citibank. But even if Citibank survives, the Treasury will not have addressed the fear that is gripping the banks. For this, the Treasury and the Fed need to change the rules of the game: They have to tackle head-on the two issues that conspired to lead to AIG's swift collapse.

First, they should change the mark-to-market rules that have made the balance sheets of financial institutions captive of swings in asset market prices. These rules exaggerate the importance of unrealized gains and losses, and exacerbate economic volatility by undermining stability in the banking sector. Instead, consideration should be given to rules that allow for the smoothing of unrealized gains and losses over time, as is the case in pension fund accounting, to mitigate market volatility by recognizing gains and losses over a multi-year period.

Second, immediate regulatory action should be implemented, vitiating the linkage between changes in credit ratings and collateralization requirements under outstanding swap agreements. While changes in bond ratings have always had effect on an entity’s cost of capital over time, the rating agencies never intended for rating actions to trigger cataclysmic events. In fact, until the collapse of AIG, the collective impact of the collateralization triggers in swap contracts was barely recognized as a material risk factor for financial institutions. Any counterparty who objects to this change should be free to void the agreement to which they are a party.

With the implementation of these two steps––changes in the mark-to-market rules and removing the collateralization provisions from existing derivatives contracts––the Treasury can immediately reduce the pressure on Citibank and on other financial institutions. Then they can focus on the real job of recapitalizing the banking system, and perhaps the banks will get back to the business of lending.

Thursday, November 20, 2008

Bailouts. All the rage.

The debate over the bailout rages on.

On the one hand, the companies involved have only themselves to blame. No one denies that they brought this on themselves. The nation watches incredulous as the wealthy CEOs fly into the nation’s capital on their private jets and claim that it was not their fault––and begrudge anyone who suggests that their compensation should limited if they receive federal aid.

It is hard not to want to let them face the rigors of bankruptcy. Let others in their industry who did not make bad decisions reap the rewards of their strategic wisdom and take market share from those made bad choices. That is the way it is. That is the way it’s supposed to be.

Those arguing for the bailout question whether the economy can sustain the wreckage and havoc that will ensue if the companies are allowed to fail. They argue that rather than risk the widespread repercussions of a collapse, we should invest in the companies, shore up their financial condition, and hope they make better decisions going forward.

So we held a national debate and in the end, after the cajoling of Wise Men from across the Capitol, Congress and the President approved the $700 billion bailout for the finance industry.

We had a referendum on pain and our willingness to walk the walk of our capitalist principles, and we decided we just weren’t up to it.

Now come the automakers. It is like deja vu all over again. Once again, the companies have brought this on themselves. Once again, the wealthy CEOs fly in on their private jets, and show nothing approaching accountability for their circumstances.

And once again the fundamental question is whether the companies and their stakeholders will suffer for their own bad judgments, and whether their competitors who have demonstrated strategic wisdom will be allowed to take market share from those who made bad choices. The way it is supposed to be.

Those arguing for the Detroit bailout question whether the economy can sustain the wreckage and havoc that will ensue if the companies are allowed to fail. But this time, the resistance is fierce.

The hypocrisy of the moment is profound. This is not an argument for or against aid to Detroit, but against the hubris that now surrounds the debate. Would a debtor-in-possession bankruptcy process be a better choice over the long term to secure a better future for GM and Ford? Perhaps. Are other American automakers that are highly successful in the marketplace—Toyota, Honda, Nissan, BMW et al—disadvantaged by a government bailout? Sure.

And each of these arguments could have been made in the financial bailout. Like the automakers, the best efforts of Hank Paulson may just be delaying the day when Citibank succumbs, and newer, foreign-owned banks with a growing presence—Toronto Dominion, Banco Santander, FirstBank—emerge from the middle market to replace those at the top who fall under the weight of their bureaucratic indifference to the customer and their derivative-laden balance sheets.

As Joseph Schumpeter famously wrote, the process of Creative Destruction is the essential fact about capitalism. It is the driving force of innovation and growth. But as we are now witnessing, there is destruction and collateral damage along the way. Sometimes the damage is small and incidental, and sometimes the damage is cataclysmic.

We already chose not to face head-on the consequences of failure on Wall Street. Now, as the economy is coming undone, one has to question whether this is the moment to let GM and others fall under the weight of their legacy cost structures. The arguments for bankruptcy and the urgency of finally having Detroit make the real changes that are essential to its future are valid. But bailout opponents should not kid themselves into thinking that the process will be smooth or without collateral damage.

All of the obligations that GM will walk away from in bankruptcy—retiree healthcare, support for redundant dealerships, bond and lease payments for redundant facilities—are payments that someone else receives. Our essential challenge as we address the economic recession is to sustain economic activity and demand in the marketplace as consumers and companies reduce their spending. A GM bankruptcy will exacerbate this challenge and increase the costs to government at all levels to sustain economic activity and mitigate the collateral damage.

In many ways, our response to the auto industry is shaped by our response to the financial collapse. We rose to the urgency of that challenge, and now watch incredulous at the apparently arbitrary allocation of those billions of dollars of our money. Why has $150 billion been allocated to secure the interest of counterparties to AIG derivatives rather than simply to secure the policyholders? Why have we given tens of billions to the largest commercial banks only to see them cut back lending and increase banking fees? Why are we giving money to American Express––the lender to the richest Americans––while little is done for homeowners? Why have we rewarded failure and not instead mitigated collateral damage and allowed those who have been successful in the marketplace to win?

We have watched one bailout unfold, and we have not been impressed. We heeded the Wise Men, and now we feel violated.

But how do we now hold failing auto companies to a higher standard? And why now, when money is being tossed around the Street like confetti? Is it because this time the beneficiaries would be autoworkers and retirees rather than well-heeled moneymen, who to this day have yet to apologize to the nation for the destruction they have wrought?

Tuesday, November 18, 2008

Building US foreign policy in a networked world

Faced with a choice for Secretary of State between Hillary Clinton, Chuck Hagel and Bill Richardson, President-elect Obama’s choice should be clear. While all of them have strengths to serve the new president well, only Governor Richardson brings both a depth of experience and a philosophical commitment to Barack Obama leadership style.

Each of the candidates brings great strengths to the position. Hillary Clinton would bring unrivaled superstar status to the position, and provide unmatched energy and focus to push ahead the Obama foreign policy agenda. Like her husband, she is a pragmatist who will quickly grasp the nuances of every issue, and she will bring––as she does to all things––a tremendous motivation to succeed.

Chuck Hagel is a very different choice. He is a serious student of foreign policy and military affairs, with a deeply grounded understanding of the international world. Unique among the Washington crowd, Hagel understands and has spoken on the most serious foreign policy challenge that we face, which remains our relationship with Russia. Our ability to address all other international issues—Iran, Iraq, the Middle East, nuclear proliferation, drug trafficking, and financial integration and regulation—will be either facilitated or undermined by our relationship with our former adversary. Hagel understood immediately our error in embracing the Kosovar declaration of independence, which undermined the primacy and principles of international law, and the far-reaching consequences of that action, which continue to unfold. Hagel recognizes the importance of American leadership that embraces the world in all its complexity, particularly after years of hubris and empty threats that have eroded our credibility and capacity to lead.

But in Bill Richardson, President-elect Obama can choose a seasoned international diplomat and negotiator who truly embraces the core of Obama’s worldview. Like Obama, Richardson understands and has practiced a style of diplomacy and leadership that begins with listening, and that is grounded in the view that even as disparate parties may have widely differing agendas, the most complex and intractable conflicts can be addressed if differences are acknowledged and respected, as a first step toward identifying and achieving common goals.

In addition, Richardson would bring to the administration a broad network of relationships across the international community and an ability to take on the portfolio of State with no learning curve. From his time as UN Ambassador, to his range of assignments as an international negotiator during both Democrat and Republican administration, Richardson has built an international reputation for diplomatic skill, integrity and credibility.

Much has been made of this being a time of transition from a uni-polar to a multi-polar world. But this is not an accurate reflection of the world that President-elect will inherit. The US will remain the dominant military and financial power for decades to come. However, the significance of that status is what people expected it to be, and the world has not, and will not in the future, march to our tune on account of that power. The emergence of asynchronous warfare and strategy has proven to be an effective counterpoint to US military dominance, and years of US deficits have led to the emergence of China and other countries as powerful financial players, even if the dollar remains dominant in times of crisis. Today, our power gives us the capacity to lead, but will not compel others to follow.

The celebrations around the world that greeted the election of Barack Obama reflect the hope that positive and effective US leadership will reemerge in the world. But that leadership must reflect a new world of struggling and emerging democratic nations that will each need to chart their own politics and path forward. This is a world that will need American support, encouragement and direction, but will not respond well to hubris or dictates from foreign soil.

The world today is defined by overlapping networks. National identity remains elemental, but in almost every conflict across the globe, we are witnessing the influence of transnational linkages and networks that put a claim on community identity. Afghanistan, Georgia, Kenya, Kosovo, Indonesia, Iran, Iraq, Lebanon, Palestine, Russia, Sri Lanka, Syria, Timor, Ukraine, Zimbabwe. All of these nations are facing conflicts where religious, ethnic, tribal and family identities are threatening the primacy national identity as a unifying force. These challenges will be exacerbated rather than solved by democratic reforms––national unity was easier to maintain at the point of a gun––and demand the development of national and transnational institutions to create legal, political and regulatory frameworks for the new century.

In this world, US leadership and policy will need to focus on multiple levels and strategies. At the highest level, the US must define and focus on its core strategic interests. This is and will always be its primary priority. At the same time, the US must implement policies that encourage and support regional networks and leadership to engage regional conflicts and issues. The world of emerging and evolving democratic states must, under American leadership, learn new skills in conflict resolution. And all roads will no longer lead to Rome.

This is a world that is ready for the leadership of Barack Obama, who built a political campaign based on a philosophy of uniting people with vastly differing identities toward common purpose. This is the world in which Bill Richardson has been immersed for decades. A world he understands from extensive personal experience, and one where, like Barack Obama, he is greeted warmly wherever he goes as one who has the knowledge, understanding and philosophical stance that can enable him to bring together even the most entrenched adversaries.

Saturday, November 15, 2008

Farther down the rabbit hole

The longer this goes on, the more absurd it is becoming.

Hank Paulson may know what he is doing. He may have insight that is lost on the rest of us. But then again, he might not.

It is not easy to suggest that a man with the pedigree and swagger of a former chairman of Goldman Sachs does not know what he is doing. But there it is.

Over the past few weeks, in the name of recapitalizing the banking system, we have witnessed the largest concentration of financial power and privilege in a century. Three of the new titans of the banking world––JPMorgan, Bank of America and Citibank––have emerged far larger and more powerful than before the financial crisis began. Their assets have ballooned. Regulation W has been waived, and FDIC deposits are now unfettered by restrictions put in place almost a century ago. And they have new infusions of taxpayer capital that some have unabashedly suggested will be used to acquire regional middle market banks and future expand their dominance in the marketplace.

Not to lose out on a good thing, American Express this week sought and received Fed approval to convert itself into a bank, so that they could get in on the action.

This, Hank Paulson suggested, marked the Government’s initiative to unlock the consumer credit market.

The irony, of course, is that these are not the institutions that will pull us out of the recession. These are not the institutions to which small businesses turn to finance the great American engine of job creation and growth. Those would be the community banks and middle market banks, that have largely eschewed the risks of derivatives and securitized obligations that have brought the larger institutions and hedge funds to their knees. And those are the institutions whose plight has been largely overlooked by the bailout strategies that Hank Paulson has pursued. Far from being helped, those institutions have been placed at a competitive disadvantage by the aggressive steps that the Treasury and the Fed have taken to concentrate financial power in a handful of dominant institutions.

We are now in the Alice in Wonderland phase of the financial bailout. The world of public policy has disappeared into the rabbit hole, and we have no idea where we are going to end up. But it is now clear that Hank Paulson has no idea either.

The greatest failure of the bailout has been in not letting institutions that did stupid things fail, and to focus public policy on how to mitigate the public and systemic consequences of that failure. In the case of Lehman Brothers, we failed to anticipate and prepare for the downstream consequences. But instead of learning the lesson that we must look down the road and anticipate systemic consequences, we turned our back on the core principle that failure is essential in competitive markets and exacerbated our problems in our approach to AIG.

The collapse of AIG came as a result of its exposure to the collateralization provisions of its credit default swap (CDS) business. To date, the bulk of the $150 billion federal cost of bailing out AIG has gone to making good on the collateralization obligations under those CDS contracts. Essentially, instead of protecting the AIG policyholders and otherwise letting AIG fail, and reaffirming the principle that stakeholders––from bondholders to CDS counterparties––are at risk in the marketplace, the Treasury chose to protect the rights of CDS counterparties with public dollars.

Halfway through the $700 billion, we are still facing two central problems. First, Paulson, Bernanke and Congress have yet to find a way to unravel the mortgage-backed securities market. The central issue here is that once mortgages are pledged in a pool to multiple investors, the terms of any individual mortgage cannot be renegotiated without impairing the contract rights of some of those investors. As a result, while mortgages held in whole by a single institution can be renegotiated, those that have been securitized may not be able to be fixed. This means that for a subset of mortgages, a foreclosure process may not be avoidable. If this is the case, federal policy should address the affects of foreclosures on families and communities, and let the process of unwinding the CDO market work itself out.

Second, the risk that credit default swap contracts present to the financial system has to be recognized and addressed. CDS contracts are essentially insurance policies against financial loss on bonds, where one party pays a premium to the other party, who agrees to make them whole in the event of a bond default. The issues are twofold. First, there is no regulatory framework that regulates the capital reserves that an institution must hold to write this type of insurance. Second, there is no requirement that the purchaser of the insurance actually own the bond in question, and there is no limit to the amount of insurance that can be written against any given bond. As such, the CDS market has become a purely speculative market that––as Michael Lewis suggested in his magnificent epilogue to Liar’s Poker––allows investors to make side bets in the bond market without actually investing any money. It is, simply state, a market with infinite leverage.

JPMorgan, BofA and Citi have approximately $13.7 trillion of credit derivatives outstanding, in compared to total combined assets of $3.9 trillion, while JPMorgan alone has approximately $7.9 trillion outstanding, in compared to total assets of $1.4 trillion. These banks will argue that their derivatives “book” is evenly balanced between long and short positions. But this ignores the fact that AIG did not collapse because of its exposure to the credit events in its CDS portfolio, but rather because of the collateralization requirements that ensued in the wake if its bonds being downgraded below “AA.”

Today, these three banks are rated "AA," with at least two of them facing downward pressure on their ratings. However, it is likely that even JPMorgan CEO Jamie Dimon––the reigning superstar of the financial firmament––does not know how much collateral JPMorgan would be forced to post to their CDS counterparties in the event they were to be downgraded. But suffice it to say that each of these banks have CDS books that are several times larger than that of AIG, and any such downgrade would likely wipe out their capital reserves.

Even as Congress and the Treasury look for solutions to the mortgage foreclosure problem, they should act immediately on credit derivatives. Three steps are warranted. First, a complete industry database must be created to track contracts, exposure and collateral terms. Second, a regulatory framework must be created to establish capitalization and reserve standards. And third, similar to the insurance industry regulatory framework, the federal government should immediately levy the equivalent of an insurance premium tax on credit derivatives to fund the public costs of financial protections and regulation.

Today, insurance premium taxes are levied in the range of 5% of premium volume. If CDS pricing averages 200 basis points on the outstanding $62 trillion, a similar fee on the annual CDS payments would generate approximately $62 billion, and provide a reasonable start at amortizing the costs of the federal bailout. And perhaps, if the industry complained that the cost was too high, it would serve the higher purpose of providing an incentive to unwind the most highly leveraged sector of our financial system.

Sunday, November 02, 2008

The prospect of hanging concentrates the mind

“The prospect of hanging concentrates the mind.” Samuel Johnson.

After decades of fretting over the low American savings rate, Americans are putting away their credit cards and hunkering down for a long, cold winter. And the rest of the world is trembling at the thought.

The anticipation phase of this financial crisis is coming to an end. In a world of six-hour news cycles, people are beginning to realize that nothing is going to be fixed quickly. Last week’s god, Hank Paulson, is this week’s afterthought.

No, he did not fix it. No, he does not know what we should do with the $700 billion. No, he does not know what AIG did with the $100 billion. And no, he does not know what to do next.

Soon, people will turn off the cable news circus. The election will be over, and there will only be the uncertainty of what lies ahead.

For a president Obama—willing to turn the page on the Neoconservative rhetoric that has dominated American foreign policy of late—the financial crisis will offer a dramatic opportunity to reshape international relations, in positive and constructive ways. After all, the denouement of the crisis that is slowly placing a vice grip on nations across the world has brought a new clarity to international relations. And as each nation now looks out over the precipice, the hubris that has characterized the past few years may give way to a new willingness to build bridges.

In the early moments of the financial debacle, our allies in Europe—to say nothing of those across the world resentful of our new militarism—could barely conceal their satisfaction as the dollar fell, the price of oil rose and the end of the era of US dominance loomed. But that moment was fleeting before the interconnectedness of the 21st century economy became the dominant fact of the new world order.

Within a few short weeks, new realities emerged. As stock markets around the world plummeted—from 40% across Europe to 60% across Asia to over 70% in Russia, Ireland and Iceland—the interdependence and integration of national economies, and the ease of migration of capital, undermined newfound notions of prosperity from Ireland to Russia.

In European capitals, the ascendant notion of an economic decoupling from the United States fell by the wayside as nations quickly sought to protect their own interests and the euro crashed. In Russia, the collapse of energy prices demonstrated the fragility of an economy that has failed to build legal institutions and will soon show what little protection Russia’s new financial reserves can provide in the face of an international recession.

At the same time, for the United States, two dominant doctrines of the post-Cold War era have been discredited. First, the consuming conflicts in Iraq and Afghanistan have demonstrated the limits of overwhelming military power to force change and democratization. Second, the financial crisis and final capitulation of Alan Greenspan have demonstrated the limits of unfettered free markets and the power of uncontrolled ambition and greed to foment global chaos.

Today, the reality of economic interdependence can transform political relationships, as evidenced by our relationship with China. Two years ago, as Europe was trumpeting the emerging decoupling, China demurred. China’s communist leaders grasped the implications of the integrated international economy better than her European counterparts, and understood—as good Marxists—that economic imperatives trump traditional political arguments. China tightly linked her currency to the dollar and, after decades of saber rattling, has now tempered her threats to take back Taiwan by force.

Our relations with China are a marked contrast to our relations with Russia. For years, we have dealt with China quietly and respectfully—despite domestic protests regarding Tibet and religious persecution. With Russia, nothing has been quiet or respectful, but rather our policy has been long on hubris and trapped in Cold War rhetoric, if not ideology.

In early October, Chancellor Angela Merkel visited Moscow, where she announced that Germany would oppose efforts to admit Ukraine and Georgia into NATO. Her announcement has offered the US an opportunity to step back and reframe our relations with Russia. A new administration will now have the ability to rebuild our relationships with Russia, as with many other countries, on principles that reflect the new economic realism of international economic integration and our own understanding of the limits of military power. Simply stated, Russia—as China has accepted—can no longer impose her will at the point of the gun, while we must lead with a tempered rhetoric in a world where tanks alone cannot achieve our goals.

The strength of the dollar in a time of global crisis has reaffirmed the critical role of American leadership—to say nothing of the importance to the rest of the world of a vibrant American economy—to others. At the same time, an end to American hubris and a touch of the humility that George W. Bush once embraced, may allow us to provide the leadership that the world now desperately needs.

For a new president who grasps how dramatically the world has changed in the past month, and who appreciates both the complexity of international economic integration and national identity, this will be a time of unprecedented opportunity.