One of the great things about having Obama as president is that Paul Krugman will now put more focus on economics and less on polemics. I was a classmate of Paul’s at MIT, and I remember him as the most natively brilliant of all of us in terms of economics. There were others who had stronger mathematical skills or who walked in the door with more economics training, but it seemed that he was genetically wired for economics. And now that there are fewer Republicans for him to kick around, he can get focused on what he does best.

But that doesn’t mean he is always right. Well, when it comes to economics I doubt he is ever actually wrong, but he might not fit the full story within the space constraints. And this is the case with a recent column of his in the New York Times related to government bail outs. He used a fictional bank called GothamGroup – I don’t know if he had any particular bank in mind, I suppose it was based on some Batman reference – to explain how the government cannot alter the basic math of the markets. If a bank has liabilities that are greater than its assets on a mark to market basis, then the bank is effectively in default. The government cannot change that; if it does not want it to fail, then it has to give the bank enough money to push it back into solvency, which means giving the equity holders a gift at the taxpayer’s expense.

The point left unsaid is that the government, unlike you or me or some corporation, is in a position to change the reality on the ground. They can take steps to alter the nature of the markets. They can push down mortgage rates, add tax benefits for new mortgage holders, and push losses forward by forcing changes in accounting rules. They can push inflation up to make all debts lower in real terms, thereby differentially taxing the lenders to the benefit of the borrowers. They can encourage the formation of clearing corporations for swaps or other instruments, thereby improving the liquidity and credit-worthiness of those markets. They can buy up weakened assets and lock them up for as long as they want, so that no one needs to look over the shoulder and wonder if an avalanche of securities is going to sweep them away should they start to invest.

An investor may be hesitant to take on the assets that are clogging up the banks. They would have a hard time finding the capital to buy them, and they have uncertainty about the future. And they fear that once they take assets on, they may not be able to dispose of them if the economy continues its tailspin. Little capital to invest, uncertainty about the future, illiquidity: no wonder the mark to market on these assets is so low.

But not so for the government. The government has no capital constraints, no concern of being forced into liquidation, and as far as uncertainty about the future, to a large extent it creates that future. The government makes the rules; if the government were clever about it, my bet is that they could make a windfall from this mess by buying up everything in sight and then changing the market reality.

There is not much mystery about how banks ended up in such a mess. It was not the malfunction of sophisticated risk models, nor was it a “100-year flood” event that swamped risk controls that would have been adequate in normal times. It was simply a huge and unrelenting build up of inventory in illiquid and often complex securities. A build-up that was there to be seen and corrected.

There was nothing tricky in fixing this problem before it got out of hand. When you are seeing the inventory of complex structured products grow from a few billion dollars to ten billion, then on their way to 20 or 30 or 40 billion, a natural question to ask in the course of the build-up is “why aren’t we selling any of this stuff”. And a natural answer to that question is “maybe we aren’t pricing it correctly”. Any risk manager with a fifth grade education will note that if the price of the inventory is off by just ten percent, that will mean a loss of billions of dollars, and so will propose selling some of the inventory, say a few billion dollars worth, and see the price at which it clears. At that point, the gig will be up.

So why didn’t this happen?

One hypotheses is asleep-at-the-switch incompetence by the risk mangers: they just missed the inventory build-up. But given the simplicity of the problem and the fact that any of these banks have hundreds of personnel in the risk management division, that’s hard to believe.

A second hypothesis is incompetence or poor incentives in senior management: the problem was passed up the chain of command and then ignored. This seems reasonable; there are, after all, tensions that pull against the in-house Cassandra. Senior management is reluctant to reduce risk because it means lowering earnings. And management gets backing for this from a powerful constituency, the traders who control the profit centers and make their money by taking risk. The traders are at loggerheads with the risk manager because of skewed incentives, the so-called “trader’s option” where if the firm wins they win while if the firm loses big time they miss their bonus for the year and head off to greener pastures. Indeed, senior management might be swayed by similar incentives.

Under this hypothesis the risk failure within the banks is organizational; it has to do with incentives, communication and plain old fashioned bureaucracy.

So how do you fix it?

The government needs to create a market risk management function with direct lines to the Chief Risk Officer of each financial institution. The CRO should be required to provide full risk information to the government risk authority. It sees whatever he sees. And it should go one step further, to require the CRO to notify the government risk authority of any risk concerns that have not been resolved by senior management. In essence, the CRO would have dotted-line reporting to his government counterparts. Think along the lines of the Sarbanes-Oxley Act, which requires the CEO to attest to internal controls and certify the accuracy of the financial statements.

As important as the specifics of the structure is the spirit with which the regulatory role is executed. For the CRO engaged in fulfilling his responsibilities, the government risk authority can act as his ombudsman, an outside voice with the power to get things done if his own voice is not being heard within the firm. The CEO is less likely to ignore risk concerns if he knows who might be making the next knock on his door. And if the CEO has a legitimate disagreement about the degree of risk, he might welcome the outside view.

For this to work, we need to change the mindset behind regulation. Marching in with a subpoena in one hand and a sixty page questionnaire in the other is not the way forward. Which means we also need a different type of regulatory staff. Some jobs cannot be done by SEC lawyers or career government workers. We need to entice market professionals into government service, market professionals who are on par with those in industry. It might cost some money to get them on board, but I bet the bill will be way south of a trillion dollars.

Dawn Corrigan has written a rendition of Dr. Seuss's The Lorax, replacing the forests with the markets and with me in the starring role.

The original version focuses on the damage of clear-fell logging, and is used by Doctors for Native Forests in their fight to preserve, well, native forests:

I have recommended in various forums that we need a government-level market risk manager. (See my House testimony (October, 2007) and Senate testimony (June, 2008), both linked via posts in this blog, and the Preface for the paperback edition of A Demon of Our Own Design). Such a role has also been recommended by the Treasury in the form of a market stability regulator.

I was discussing this idea yesterday with a colleague in government, and he mentioned that one concern for such a role is the potential for a concentration of power. Risk taking is at the center of the financial industry, and whether it is the Federal Reserve, Treasury or SEC, the ability to dictate risk limits puts this role in the position of controlling the industry’s profitability.

To answer this concern, it is useful to make a distinction between risk management and risk monitoring. In the financial industry, be it in hedge funds or in banks, what is called risk management is really a risk monitoring function. The risk management team, headed by the Chief Risk Officer, oversees the aggregation and analysis of exposures. But it does not make decisions on the appropriate risk appetite for the firm, and it does not unilaterally set the risk limits or otherwise force the risk takers to hedge or reduce their positions. If the CRO thinks action is needed, the baton is passed up the chain of command to the firm’s decision makers. This might be the head of the trading division, the CFO, the CEO, or a risk management committee with these as its members. The decisions of how much risk to take, the limits to set, when to make exceptions all are made at this level.

A similar structure could exist for the risk management role within the government. The role of risk manager would be staffed by technocrats, in the positive sense of that word, who would develop systems to acquire the necessary risk information from the institutions, analyze that data and determine if new areas of risk are emerging. They would connect with their industry counterparts, the CROs of the various institutions, to understand areas of concern, to help identify common or emerging risks, and to constantly refine the risk management process. If a market crisis did occur, they would have all of the data at their disposal to revisit the risks to monitor and the limits to set. Think in terms of what the NTSB does when there are airplane accidents. All of this would lead to recommendations to a decision making committee, perhaps a subcommittee of the House or the Senate.

Don’t worry about too much back and forth with the decision makers. On a practical level, it would be rare for the government risk manager make one-off suggestions that this or that bank lower its risk beyond the risk targets that have already been established. More likely, the government risk manager would see that a number of banks are starting down a particular path, building up exposure to a new market or diving into a particular structured product space, and recognize that, while each bank’s actions might be reasonable on a stand-alone basis, there is too much concentration and potential systemic effect once the exposure is aggregated across the banks.

And, by the way, no one can make such an observation in our current regulatory structure.

The Madoff Ponzi scheme will (I hope) be the high watermark for financial fraud for many decades to come. It is hard to overstate the harm it has done, with lifesavings and fortunes lost, charities and schools left foundering.

“It fell off a Truck”
Did his investors really believe Madoff was doing split-strike conversions? Given that there were not enough options in the world for Madoff to do such a strategy? And given that no one in the industry heard of him as a player in that market?

An alternative view is that the split-strike conversion story is the equivalent of the “it fell off the truck” story for people buying stolen goods; that investors suspected he was involved in illegal front running, and would just as soon not have had that spelled out for them while the money kept flowing in.

It’s the same old story, just bigger – and smaller
Bigger because people have more money. Bigger because it is easier to create links and indirect “circles of trust” by using banks and other feeder funds as agents. Bigger because it was bigger: people implicitly trusted the regulators to do their job, and thought that surely nothing could be fraudulent if it was this large and well known.

But part of his genius was that in one respect his scheme also was smaller. He did not make the classic confidence artist’s play on avarice. The good, old fashioned Ponzi schemes are of the get-rich-quick, double your money in three months variety. Madoff’s was conservative, offering lower expected returns than many other investment opportunities.

Putting all your eggs in one basket
Madoff could get away with modest but steady returns because with credit so abundant his investors could use leverage to push the returns up. My guess is that in many cases the people who were wiped out did not have their entire portfolio in just this one fund, but rather borrowed money to create a levered position. If you can make 10% almost for certain, why not lever four times and get 40% return with a little more volatility? Because of that leverage, the fund’s failure engulfed their other investments.

We are shocked, shocked
The day after the story broke, I wondered why Madoff didn’t just grab $30 million and skip town. The likely answer is that then his kids would have been left holding the bag. I would have loved to hear the conversations between him and his sons the night they heard the gig was up, and decided they would have to turn him in.

How could anyone so close to the scheme, and in the market making business to boot, not see any of the red flags that Harry Markopolos was waving in front of the SEC for the past ten years? I wonder if they had all of their money in their Dad’s fund?

Is there a managed account in your future?
A lot of investors are going to be asking, “So remind me again what the problem is with putting me in a managed account?’ Why can’t a hedge fund operate by doing trades pari passu across various client accounts – especially if the fund is in liquid markets? With a managed account the investors then have control over their money, so it is a lot harder to do any sort of monkey business.

The usual argument is the risk of transparency. In most hedge funds, I don’t buy it – especially if transactions are available for view only with a delay. In any case, my bet is that we will see more demand for managed accounts down the road.

Are we all a Ponzi scheme?
I suppose it is irresistible. If you are a columnist who has to find something to write about three times a week, latch onto the Madoff story with a metaphor to the growth of leverage by banks and individuals. Even intellectual luminaries like Paul Krugman and Thomas Friedman have gotten into the act.

But I don’t see the connection. With Madoff you have someone who is committing fraud. With leveraged investing you have people making investment decisions. Those decisions might not have been the right ones ex post, but a Ponzi scheme?

There is plenty to think about without straining that hard. Still, I don’t think we’ve heard the last of this.

Sometimes it is best to let the patient die. At least if the patient is a company. A company can be resurrected, and enjoy a new life no longer stricken by the debilitating weaknesses that left it lingering at death’s door. Weaknesses like encumbering labor agreements, pension liabilities and health care obligations.

The pleas of the Big Three are those of the management and of the equity holders they represent. They do not have much interest in the hereafter. They would have the company cling to life by the last thread, keep it on life support for as long as it is offered, even make a devil’s bargain to trade the possibilities in its second estate for more time, however impaired, in the current one. Management and the equity holders will not share in the corporation’s afterlife. If it dies, they are gone, no matter how bright the prospects are for the company in its resurrected state.

Thus the equity holders can end up on the wrong side of one of economics’ most prickly conundrums, the agency problem. Usually this problem pits the managers of the firm against the owners; i.e. do the managers of a firm have interests that are aligned with the owners of that firm? In the current crisis the agency problem is: do the equity holders act in the best interest of the firm as a robust, competitive going concern? Do they have an interest in the long-term prospects of the firm, which is our point of interest if we are the government making the bail out decision?

If the answer means pulling the plug, then of course they do not. They will bleed the cash flow to have the firm stay afloat, exert their will to live to the detriment of the future prospects of the firm in a reorganized form. And they will be urged on by those with an interest in the encumbrances that weigh the companies down now, but that will be excised postmortem.

What is surprising in this death drama is that here, in the non-ethereal plain of corporations, we get to observe the passage into the after-life. We get to know the better world where these firms are heading. For example, we can look at what happens to airlines. It seems one airline or another goes into Chapter 11 every few years, and yet they hardly miss a flight. We don’t worry that the planes will start to fall out of the sky; if you didn’t read the papers you might not even know what happened. It is almost a part of the business plan. An airline starts off with the advantages of a new fleet and a low cost work force. Over time the fleet ages, the labor force works its way up the pay scale, the union rules clog the arteries, and costs finally squeeze the life out of the margins. So the airline goes into Chapter 11 and starts the process over.

As Congress deliberates on the Big Three, it should recognize the agency problem it faces with management. And it should look to case studies of reorganizations to weigh the shackles that bind the companies in the current sphere with their prospects in the hereafter.

There is life after death.

I was recently asked to testify in a Senate hearing "to explore the role of financial derivatives in the current financial crisis, the current system for regulating them and recommendations for modifying the regulatory system".

This hearing was by the Committee on Agriculture, Nutrition, and Forestry, chaired by Senator Harkin of Iowa. That might seem like an unusual place to deal with the regulation of esoteric financial products, but this committee has oversight for the CFTC, because the first futures contracts were agricultural, and the CFTC has oversight on swaps and derivatives, because they have characteristics similar to futures.

I was not able to accept the invitation to testify at the hearing, but it was still worth it, because in his letter, Senator Harkin explained that "You were strongly recommended for your knowledge and insights on this subject by Warren Buffett in a conversation I had with him yesterday". That alone makes the letter worth framing. But although I could not testify, I exercised my first-amendment right to send along off-the-record comments (you can do it too). I will give excerpts from these comments here:

In academic theory, derivatives and swaps are intended to help "span the state space"; that is, they are intended to allow investors to efficiently hedge their specific risks, to more precisely meet contingencies of the market, and to mold their returns to meet investment objectives.

In practice, however, swaps and derivatives are often used for less lofty purposes. They are used to: avoid taxes (for example, total return swaps are used to take positions in UK stocks in order to avoid transactions-based taxes); take exposures that are not permitted in a particular investment charter (for example, index amortizing swaps were used by insurance companies to take mortgage risk); speculate (for example, the main use of CDSs is to allow traders to take short positions on corporate bonds); lever beyond an allowed level; and take risk off-balance sheet, where it is not as readily observed and monitored.

The more complex swaps and derivatives not only find ready demand by serving these functions, there are strong profit incentives for the investment banks to supply them. The more complex the instrument, the greater the chance the investment bank can price it to make profit, for the simple reason that investors will not be able to readily determine its fair value. And if they create a product that is exclusive to them, they can also charge a higher spread when an investor wants to trade out of it.

Viewed in an uncharitable light, derivatives and swaps can be thought of as vehicles for gambling; they are, after all, side bets on the market. But unlike the more common modes of gambling, these side bets can pose risks that extend beyond losses to the person making the bet. There are a number of ways the swaps and derivatives end up affecting the market:

Those who create these products need to hedge in the market, so their creation leads to a direct affect on the market.

Those who buy these instruments have other market exposures, so that if they are adversely affected by the swaps or derivatives, they might be forced to liquidate other positions, thereby transmitting a dislocation into other markets.

The value of some derivatives can have real effects for a company. For example, the credit default swaps are used as the basis for triggering debt covenants, so if the swap spread rises above a critical level, it can have an adverse effect on the company.

The use of derivatives and swaps can pull capital away from other productive uses. Because these are side bets, capital employed in these markets does not find an end-user.

Those who are writing the derivatives are in effect providing insurance to the buyers, but without any regulatory requirements. Often those writing these instruments are not in a well-capitalized position to pay out in the event that the option goes into the money.

In terms of regulation, here are some points to consider:

The regulators must know who owes what to whom in these markets. Right now there is no way to ascertain the effect on the swap and derivatives markets of a firm failing, because regulators do not know the web of counterparties to these instruments.

We should consider standardization of instruments and make the instruments simpler. As I point out in my book, complexity of financial instruments is one of the sources of market crisis.

We should consider having swaps and derivatives move as much as possible away from party-to-party into a clearing house. This would improve monitoring and provide for a lower risk of default.

There should be stronger oversight on the use of these instruments. Who is buying and selling them,and for what purpose. Perhaps require participants to specify if the instrument is being used for speculation or hedging. Regulators should also ascertain if the use is reasonable; are these instruments simply being used to move risk off-balance sheet or to take on positions that would have been prohibited if they were executed in another way.

[I have added responses to some of the comments]

On June 19 I testified before the Senate Banking Committee, at a hearing of the Subcommittee on Securities, Insurance and Investment. You can read my prepared testimony here.

Going forward, I will not be doing new posts for this blog on a frequent basis. (You can probably see things have already been tailing off).
Here is a review of my book that I thought was particularly interesting. It is heartening to think that my book has a little bit of something for everyone.