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.