Leaders should, I think, bring out the best in people: not
just appeal to our better selves but get us to find better, more accurate
answers and drive better solutions – that’s simply how you make things better. Of course, as Paul Krugman often notes, Republican
talking heads often, if not always, get their analysis wrong. What I think is interesting and very
disturbing is that Hillary Clinton is getting the same bad quality analysis and
positions out of her supporters – chief among them is Krugman himself. Take this quote from a damning column on
Bernie Sanders view on financial market reform:
“Many analysts concluded
years ago that the answers to both questions were no. Predatory
lending was largely carried out by smaller, non-Wall Street institutions like Countrywide Financial; the crisis itself was centered not on big banks but on
“shadow banks” like Lehman Brothers that weren’t necessarily that big. And the
financial reform that President Obama signed in 2010 made a real effort to address
these problems. It could and should be made stronger, but pounding the table
about big banks misses the point.” – from Krugman’s “Sanders Over the Edge”
column dated April 8, 2016
This is pretty
naïve and a totally wrong assessment of what happened. To understand any trade you need to look at
the cash flows and see what motivated investors – in this case it’s the
proprietary trading desks that purchased the riskiest tranches or parts of Collateralized
Debt Obligations of negative amortization, high credit risk mortgages as well
as wrote the Credit Default Swaps on other tranches of similar CDOs. As a large investor, banks really could not
easily participate in the bubble in single family homes – and the prop traders
who are paid grossly to chase the hottest assets in town must have felt this acutely. You could invest in a REIT (“Real Estate
Investment Trust”) – but REITs were suffering from lower rents because the
market had rushed to ownership. You
could invest in new developments – but then you are taking on an additional
development risk. Can’t really buy individual
houses, rent them in the interim till later monetization because the logistics
are prohibitive and rents had relatively dropped. So what
do you do?
Buy the riskiest or ‘z’ tranches of
negative amortization mortgages of low credit borrowers and write CDS’ on the
other tranches of similar CDOs. From Put-Call parity this buys you a
levered position in the underlying single family homes! This is what the big boys were up to and
drove the whole stinking mess to its eventual explosive and devastating demise
– and for the uninitiated requires some explanation. Let’s start with a basic negative
amortization loan pool: the initial principal of the loan pool was $100 and
increased over a first, teaser year to $120 with no monthly payment and a
prohibitive early refinancing penalty. The
initial principal was then split into multiple tranches from the highest rated or
safest which received the first claims on any cash received to riskier tranches
that have lesser claims to finally the riskiest ‘z’ tranche – which is better known as toxic waste and normally is stuck
with the origination desk that put together the CDO. Funny thing is this time the toxic waste went
to the biggest of the big swinging dicks:
the prop trading desks who have never been known to be forced to take anything
from anyone. Wonder how Krugman is
certain that Countrywide managed to stick this to Lehman? Alas, anything is believable if you have to
throw Bernie under the bus…
This toxic waste was different you see, it got the benefit
of the appreciation in the underlying houses from $100 to $120 in the
example. At the end of the year, the
house would necessarily need to be refinanced because the rate was simply impossible
for a low credit customer to pay – no, no one was stupid enough to think that
someone who would struggle with a 6% interest loan would be fine servicing a
20% loan. When they refinanced the
mortgage, the CDO would pay back for each class of investor. If there was any increase over the $100 up to
$120 it would go to the z tranche – making it a call option on the pool of
single family homes and achieving the first part of what the prop desks wanted. See, a call option is the right but not the
obligation to buy an asset for a fixed price to the writer of the option so
that any appreciation over that fixed price goes to the buyer of the
option. The prepayment penalty was to
stop or at least ensure compensation if the abused homeowner had the temerity
to early terminate the option on the prop trader. The issue prop traders did face was that the
cost of that option was high because the less risky tranches wanted significant
discounts to finance the $100 principal – and any trader knows that a trade simply
gets better as you buy lower.
The solution is to write a put option on the same pool: it
helps pay for the premium on the call option while exposing you to reductions
in real estate prices – and you will recall that the prop desks were often after
buying all the exposure to these houses.
A put option is the right but not the obligation to sell an asset for a
fixed price to the writer of the option so that any depreciation under that
fixed price is pushed to the seller or writer of the option. How would you do that? Well any decrease below $100 when the pool is
sold would go to the riskiest tranches in the CDO – so if you guaranteed full
principal to each of the tranches then you were effectively paying out for any
decrease in the value of the houses in that year. This is, of course, the same sustaining a
loss if the house you purchased decreased in value.
One more detail: options are most valuable (option premium
less payoff at the current underlying’s price) when the underlying’s price is
exactly the strike. So what do you know,
these sub-prime and alt-A negative amortization loans did away with the need for
downpayment so that the principal of the mortgage would be equal to the current
price. Wow!
Krugman’s take on financial market reform is taken as a
major endorsement by Hillary of her position – witness her statements on the
subject in the debates. Hopefully, by
now you’ve gathered that Krugman’s analysis is quite deficient in a way he so
destroys others on – no models, no real analysis, just VSP (“Very Serious
Person”) dribble. The reality is that
where Dodd-Frank fails is that it doesn’t seek to change the landscape but
rather to put constraints on some behavior by making banks create living
wills. But is that enough? You see, as Yves Smith of nakedcapitalism.com
so often points out, banks have negative economies of scale. So if Dodd-Frank was even marginally
successful, the big banks would have immediately started to dismantle
themselves. (Poor Krugman, what does he
know about economies of scale, he only got the Nobel Prize for his
groundbreaking work there.)
The need instead is to bring back Glass-Steagall and
forcibly break banks up – and then, create “mono-line” insurers for each
category that double as sole regulators.
Separate FDICs for commercial banks, investment banks, insurers, hedge
funds without the corrupting influence of the Fed. The Fed’s role has to be in monetary policy –
and it should not be in bank regulation.
As Krugman rightly points out, congressional oversight of the Fed must
be limited because of the complexities of monetary policy. But how can a regulator with an intrinsic
need to provide bailouts to the rich and powerful not get reasonable oversight? And bailouts, of course, really are central
to banking. The House of Morgan was
literally founded on one: from losses on making the market in the French bonds
it underwrote to pay for the Franco-Prussian War; JS Morgan got lucky he got a
bailout from the Bank of England and the French paid out in full on the
bonds! And the victims if banks aren’t
bailed out are the middle and working classes who suffer in the sharp, deep recessions
and even depressions that they cause.
This version of FDICs would be different, they would be
allowed to price differently based on a public risk assessment of the
individual participant which must include its size. The one for commercial banks would backstop
any risk that the Fed took on from lending to the banks. Keeping the Fed out of regulation and
insuring that the FDIC stepped in quickly if a risk did materialize and wiping
out equity holders. Punitive insurance
rates for the systemically monstrous institutions is necessary because it
insures that the FDIC moves quickly. It
also allows for participants to exist with dimensions that a regulator can
understand and without the constraints that would impact the liquidity of the
market or the quality of prices.
Krugman’s real point, like many of Hillary’s supporters, is
that Bernie is too much like Chauncey Gardener, the main character in Being
There. Is he right because he’s smart
and wise or is it just dumb luck? It’s
easy to understand that Bernie’s absolutely right on financial market reform,
but he’s also right on foreign policy in a way that is very disturbing to them. On the key issue of the Middle East, Hillary
didn’t just make a mistake on one vote, her whole view of the region is wrong
headed: Our Saudi allies / Iran is a terrorist state. This isn’t from the last election cycle when
she had the opposite view on much, it was her view then and throughout the
debates. This is just as crazy and
incompetent as Cheney. Bernie on the other
hand has been ridiculed by the foreign policy experts for talking about a grand
coalition of Muslim countries; that they argue is completely naïve. Saudis fight alongside Iranians? How could he ever be President? But honestly, if the Wahhabi/Salafist Saudis
aren’t forced to make peace with the Kafirs in Iran, are you actually even
talking about a solution? Proof: what
made the difference in Michigan: Muslims Americans showing up in mass to vote
for Bernie! He caught perhaps the most
important nuance in the Middle East quagmire and made it central to his policy
proposal. But is he right for the right
reasons?
The same is true of the welfare state. What keeps capitalism alive is not stodgy
established companies, but the new startups that disrupt them. Simply find better solutions to problems and
get closer to customers’ needs. They are
fairy tales where people quit perfectly good jobs on a whim because they
inherently believe their idea for how the world ought to function is
better. They fight the law of the
jungle: they ensure that the lion doesn’t always win but the deer does; and
when they grow bigger and into lions themselves they too should go down to a
new deer. But don’t these people need a safety
net from the society that so benefits from their risks? This is the guts of what Bernie says, and
Hillary’s limited safety net – she sneers at his ideas – is just a way to make
sure deer aren’t encouraged too much. The lions, after all, are bankrolling her. But does he know why he’s right?
Thanks to Keara Killian who read, reviewed and edited this multiple times.
