Bankers Bonuses and Bank Reforms: why they are needed, what they might include, and are you angry yet?
by Linda Beale
A big title for a tiny little sketch of a post, I know. Not much time today folks, but if you can read only one blog posting, read the one at Naked Capitalism at the link provided at the end of this paragraph. Yves comments on the Independent’s article on bankers’ bonuses and the Wall Street firms’ incredible egos and greed. See US Banks Reject Effort by UK Bank Execs to Reign In Pay, Naked Capitalism, 022
Beale here: As you all know, A Taxing Matter has been hitting that same nail with my tiny little hammer. I think the evidence suggests that we need to take some rather drastic actions, which might include any or even perhaps all of the following:
- break up the investment banks;
- regulate their leverage and their bonuses,
- ban their flash trading
- heavily regulate their involvement in speculative gambling with derivatives (i.e., betting on positions that they don’t own). And given that their resurging profits are due to two things–(1) resuming the same casino gambling that caused the 2008 crisis and Great Recession and cost millions their jobs and (2) feeding off the public trough for TARP direct funding (the AIG bailout, etc going directly into Goldman and JPMorgan Chase’s pockets) and implicit guarantees resulting in very cheap cost-of-funds permitting Goldman et al to make profits with federal loans–we need to add a new tax for the big banks as a charge for the government guarantee that they are getting rich off of (again). The tax should be a substantial enough bite that it will force the banks to both significantly reduce their leverage and significantly reduce their bonus payment system. It can be either in the form of an excise tax based on their leverage (since their borrowed funding is what costs the government in terms of bailout potential) or in the form of an income tax surcharge that is progressively structured so that the highest rate applies to banks with the greatest amount of leverage. It could even be a tax structured as a tax on each derivative position like credit default swaps entered into that isn’t backed by a long position (so not a true hedge but a speculative bet). I don’t knw for sure which form is best (comments welcome) but I sure as heck think some version or another should be passed, and soon, else we are in for a repeat that is more disastrous than the GOP-gifted Great Recession we are already experiencing. _________________________________
crossposted with ataxingmatter
Can the liberal democrats eliminate business risk from rising and falling commodity prices and fixed investment values? The answer is no so there no basis to allow them to tinker with the economy.
http://www.fdic.gov/bank/individual/failed/banklist.html
Here is a list of 208 failed banks. A lot of them are small banks. It seems that Linda is claiming that these banks would not have failed if we made rules against derivatives and high executive pay. But where is the evidence that banks got on this list because of derivatives and executive pay.
I don’t believe her. I think the reason for the failures are falling real estare values and a general slowdown in the economy. Moreover, I think the catalyst was the real estate bubble coming to an end with the help of oil prices going up to well over $100 a barrel.
Linda wants us to pursue the fantasy of a government managed lake wobegon economy where each successive years economic growth is above average. But it is a fantasy and one I can live without. I would much rather trade off democrat claims a guaranteed mediocrity mediocrity for the free market with its higher highs, higher averages, and sometimes sharper buy short downturns.
Only two rules need be applied:
1. Banks may not hold deposits of more than 5% of GDP (imposed through an accelerated tax)
2. Banks may not be publically held companies. They must be partnerships.
Cantab claims a move to eliminate all risk is afoot….no, not at all. Never was either, by anyone.
Cantab claims Linda claims a need to keep the economic growth above average…never mentioned in Linda’s post. His own fantasy perhaps?
Cantab claims Linda thinks smaller banks have the same problems as big guy banks…a great leap of logic not evident in the her presentation.
Cantab returns a lot of non-information to Linda’s snarky ending about the GOP, and some snark of his own.
Of the over 8000 banks and savings instutions, he points to 208 and says many are smaller. Of course that’s true…there are only so many big guys.
How many, even a ballpark, would be nice, and how much money is involved compared to big guys and smaller banks, and the markets each serves which are different, all of which is available in the same FDIC link he provides… he brought up the topic of little guy banks, so should bring a bit of information to bear on this claim of his.
the greater than 10 billion asset sized banks control about 10,000 million of the 12,500 million asset pool, or about 107 big banks in laymen’s terms, and 14,649 million net income from many and myriad sources in 2009. (you know, the ones bailed out to preserve the financial system). Table lll-A. Smaller banks are facing other problems in commercial loans too, and don’t have other trading departments to share losses.
On the other hand, a really good post could be developed with some of the charts in FDIC if that was his intent. Calculated Risk does that too.
The egos and greed of the Wall Street firms are nobody’s business by their own and their clients.
List of stupid ideas
1. break up the investment banks;
There is no reason to do this and no chance of it either
2. Regulate their leverage and their bonuses,
How they run their business with regards to leverage is dependent on them putting their own money at risk and their clinents if their clients want to engage in deals with leverage.
3. Ban their flash trading
Why? This activity increases liquidity and is part of arbitrage activity that makes markets more efficient. Big players will always be the ones making arbitrage profit and there is no way you can level the paying field because of economies of scale. But do away with it and market prices will diverge more from what they would be in a fair competative market.
3. heavily regulate their involvement in speculative gambling with derivatives (i.e., betting on positions that they don’t own).
Of course they’re going to hedge on positions they don’t own. An airline that knows they are going to have to buy jet fuel 6 months from now may want to lock in the future price by going long in futures or forward contracts. The don’t own the jet fuel today but want to lock in the price in the future. And that the point of this transaction. The statement above shows a total ignorance of how futures market operate.
(1) resuming the same casino gambling that caused the 2008 crisis and Great Recession and cost millions their jobs and
Lets see rdan dodge this one. Linda is claiming that derivative caused the recession of 2008, get she can’t explain how derivatives which are a zero sum game can take down an entire economy. A zero sum game means that winners and losers balance themselves out so the net loss is zero.
(2) feeding off the public trough for TARP direct funding (the AIG bailout, etc going directly into Goldman and JPMorgan Chase’s pockets)
I seem to remember the secretary of the treasury forcing banks to accept TARP money that did not need or want it in order not to make the ones that did look bad. The TARP is a government program so it you don’t want do it then don’t next time.
The egos and greed of the Wall Street firms are nobody’s business but their own and their clients.
List of stupid ideas
1. break up the investment banks;
There is no reason to do this and no chance of it either
2. Regulate their leverage and their bonuses,
How they run their business with regards to leverage is dependent on them putting their own money at risk and their clinents if their clients want to engage in deals with leverage.
3. Ban their flash trading
Why? This activity increases liquidity and is part of arbitrage activity that makes markets more efficient. Big players will always be the ones making arbitrage profit and there is no way you can level the paying field because of economies of scale. But do away with it and market prices will diverge more from what they would be in a fair competative market.
3. heavily regulate their involvement in speculative gambling with derivatives (i.e., betting on positions that they don’t own).
Of course they’re going to hedge on positions they don’t own. An airline that knows they are going to have to buy jet fuel 6 months from now may want to lock in the future price by going long in futures or forward contracts. The don’t own the jet fuel today but want to lock in the price in the future. And that the point of this transaction. The statement above shows a total ignorance of how futures market operate.
(1) resuming the same casino gambling that caused the 2008 crisis and Great Recession and cost millions their jobs and
Lets see rdan dodge this one. Linda is claiming that derivative caused the recession of 2008, yet she can’t explain how derivatives which are a zero sum game can take down an entire economy. A zero sum game means that winners and losers balance themselves out so the net loss is zero.
(2) feeding off the public trough for TARP direct funding (the AIG bailout, etc going directly into Goldman and JPMorgan Chase’s pockets)
I seem to remember the Secretary of the Treasury forcing banks to accept TARP money that did not need or want it in order not to make the ones that did look bad. The TARP is a government program so it you don’t want do it then don’t next time.
Linda,
In addition to what Cantab said:
Reduce Leverage
The easiest way to do this is to reduce loans. Is that what you want?
Tax derivatives.
I guess you want to limit CDS, etc. The best analogy to derivatives is insurance. You want to limit insurance/risk spreading?
It would be nice if some of our resident lefties would jump in and expand on Linda’s position since it can’t stand on its own.
Let’s talk about this “bonuses” bullshit. The bonuses are related to productivity. Goldman Sachs earned $29 B in profits before compensation (http://www.washingtonpost.com/wp-dyn/content/article/2010/01/21/AR2010012101044.html) divided by 23,000 employees which works out to about $1.3 million profit per employee. Obviously the average Goldman employee is HIGHLY productive! Average compensation is roughly $500K.
Now Goldman owners/shareholders have 3 things they can do with their profits: 1) put them back in the business 2) pay more dividends 3) pay employees more. They make the business decision to 3) pay their employees more. As a result they get the best, most productive people on Wall Street. Remember that in this business dealing with billions of dollars, one guy can make a HUGE difference.
The other criticism of “bonuses” is that somehow they reward “high risk taking” for “short term profits.” This is a highly subjective statement. What is “high risk” and what is “short term?”
And the banks have way more incentive than regulators to manage their compensation system so that no one blows up their bank. Doesn’t always work (see Bubble, Housing) but I have yet to see any evidence that the same entity that sailed Freddie and Fannie into the teeth of the storm, the Federal Government, would have done any better.
They will only gum things up trying to regulate “the last problem” which will not reoccur.
It’s simple: If you are a bank and you are operating under some form of government guarantee then you don’t get to do whatever the fuck you want. Likewise if you are operating a business selling products and services that has grown so large that your failure would critically harm the banking system then you don’t get to do whatever you want either.
There was a credit crisis and economic collapse in the thirties and the result was regulation. Similar crises occurred elsewhere in the world on a regular basis, but not here. We started to weaken and remove those regulations and 10 years later we’re in another crisis. How can people look at the past, look at what has happend around the world, and look at our present situation and say that what we really should be doing right now is nothing?
What if the secret to our prosperity was that our people could act in the present and plan for the future with the assumption that the financial system was sound and we weren’t going to have huge economic swings or credit crises every 10 years or so? We’ve lost 8 million jobs over the past couple of years and spent or guaranteed trillions. How many more crises can we afford? We can’t just take people’s word that they’ll behave and everything is going to be okay. If this happens again in 5, 10 or 20 years, we’re screwed.
Well, guys, for a post that was intended almost as an “open comments” post (so throwing out a bunch of the most discussed ideas about what might be considered in financial system reform without a lot of analysis), you sure took off. But I get all snark back in exchange for my wee tad of snark at the end. Oooff.
While we can’t eliminate risk (and shouldn’t try to eliminate all risk–how boring that would be, right?), we do need to constrain risk. We need to be aware of our limitations in thinking about risk–the Taleb ‘black swan’ issues that plague investment banks (when you have a proprietary model that says its ok, you tend to substitute that model for your own thinking and then watch out). We need to make value-laden decisions about how much prudence we should employ when there is some risk of a catastrophic result–this kind of thinking is particularly necessary in dealing with the possibilities of life-changing global climate change or systemic financial collapse or nuclear disasters.
Yes, small banks can fail. When they fail, people lose. But small banks failures happen all the time just like business failures happen all the time. They don’t generally take the world economy down with them.
Now, when small banks are fail at too high a pace in conjunction with big banks’ taking the world economy down, we’ve got a problem. And when the things that interacted to bring the world economy down hit those banks particularly hard, we’ve got problems. And we should address those misguided policies that (i) encourage speculators to invest in real estate and drive up prices (ii) provide tax deductions for mortgages for pricey homes (mostly used by wealthy people) and drive up housing prices and (iii) encourage offloading of loans through securitizations to the point that there is no accountability between lender and borrower. That doesn’t mean we should ignore the elephant in the room.
RDan’s response ion the “fantasy growth” point of Cantab’s post is pretty much on point so I won’t repeat. “Growth” per se is the mecca of Friedmanian economics. I’ve argued elsewhere for a concept of “sustainable and equitable growth–meaning that growth for its sake and nothing else doesn’t necessarily do good and can in fact do harm if 90% of its value goes to oligarchic powers that be and growth that is neither environmentally sound not distributionally broad based may be worse than a steady state workable economy. Broad-based growth is more important than high rates of growth. I think, in other words, that it is important for the society writ large to share in the benefits of growth rather than a situation where one segment bears the burden while a small segment enjoys the benefit.
Cantab’s assessment of most of the ideas is not enlightening. Just saying there is no reason to break up investment banks or that leverage is fine because its just between the banks and their clients disregards the fact that financial institutions are a critical component of infrastructure, which means that reckless financial behavior
cont’d in another post
continuation of prior post
is not just between banks and clients but affects all of us.
Flash trading is not necessary for the liquidity function–it is a way that banks make money off their client’s information–basically gaming the market in ways that those without that inside information cannot. To say that “to do without it” will make “market prices diverge more from what they should be in a fair competitive market” is to presume the conclusion–that flash trading is “fair” and “competitive” and is buying the efficient market hypothesis in all its failed glory. If the EMH worked, there would be no housing bubbles, gold cornering, etc. etc. etc. Market prices without flash trading would reflect (to the extent pricing ever does, which is likely limited) the broad market participants’ views. Market pricing with flash trading reflects the gamers’ insider knowledge of how much they can squeeze out of two positions that they already know are up for trading in a very short while. Besides that, it challenges views of fairness in a relationship where the broker is serving the client and perhaps should be viewed as a fiduciary–in flash trading, the broker is using his client’s desire to make a particular trade at a particular price to make a profit behind the client’s back off the client’s trade position that the broker knows he will be able to fill.
All derivatives are not created equal and all derivatives are not credit default swaps. Most who’ve suggested some sort of ban–or at least strong regulation–of derivatives have looked back at the decision not to regulate swaps and specifically not to require transparent, exchanged-based trading of all derivatives rather than the back-do0r, customized trading that obscures leverage, clouds the picture of the amount of risk anyone has taken on, and of course utterly defeats any validity the EMH could have since there is such an assymetry of information on many of these swaps like CDS. The problem with credit default swaps is that they ARE like insurance (in that counterparties end up being at risk to repay losses) but they are NOT like insurance (in that nobody has to have an insured interest to buy them–in fact, the basic notional principal contract idea is that it references a “notional” amount that someone is treated as holding when they don’t actually do so and determines what is paid out for that amount and nobody is making sure that the insurers (the counterparties) have reserves sufficient to pay out on the contracts they have entered into). So it is a pure speculative bet. Now CDS can be hedges if people are long the position, but lots of the CDS trades aren’t hedges on long positions, they are pure bets. These types of speculative bets can move the market. The information things are priced on is the current views of the crowd that happens to be moving in or out of the market. These bets are mostly between the same counterparties–various financial institutions. They don’t get regulated to ensure reserves the way insurance is (supposed to be–and yes, we have to worry about how to avoid capture of the regulators by the regulated, always). And they’re not traded on exchanges
continued in another post
continuation of prior post
so they’re hidden. All of which favors manipulation and speculative casino trading and not something that does much for actual lending to producers.
Cantab switches the suggestion which is being widely discussed about limiting banks ability to bet on derivative positions to discussions of airlines being able to hedge fuel costs–i.e., specifically to commodities futures which in their basic function are business hedges on supplies and permit businesses to level out volatile flows. And assumes that my including the suggestion about heavy regulation, or even banning, reflects stupidity or ignorance. Name calling doesn’t help, and any reflective person will remember that the question of banning certain types of trades by banks is on the table in Congress (to the extent that anything is on the table in the overly partisan atmosphere there). So it is important that we talk about it. And, I agree with Cantab that hedging is important, Which makes this a tough issue, because it isn’t always easy to separate middleman function in hedging from speculator function. (I did, after all, invite discussion on these issues. If I had a pure “this is god’s truth” answer, I won’t be asking for people’s comments on each of the ideas.) Swaps are used for setting up position and offsetting positions in commodities between end users and suppliers. That’s a middleman function that it makes sense for banks to perform–and they need to keep their hedging book balanced. . Endusers and suppliers should be able to hedge (though we probably need to really be careful here in what we permit financial innovation to do) and brokers can act as go betweens. But brokers shouldn’t be betting on the markets themselves. Which takes us back to the Commodities Futures Modernization Act in dec 1999 when Phil Gramm pushed the “no regulation of derivates at all ” bill through. As I recall, the commodities futures exchange was arguing that derivatives should be exchange traded and regulated on along with commodities futures. That probably was the way we should have gone…..
Credit default swaps in particular are problematic in this regard because so much can be done without anyone on either side of a trade having a position at all–at the peak, I think there was almost $70 trillion of credit default swaps on less than a quarter that much underlying. We can’t just ignore that problem and try to blame the 2008 fiscal crisis on Fannie and Freddie. Or if we do, we can bet it will happen again.
Derivatives may theoretically be a zero sum game–party and counterparty, position and offset, but imbalanced books combined with losses result in AIG type situations, where letting all the pins fall where they may has systemic risk consequences alongside the party-counterparty relationship. Cantab might explain to me, in my stupidity and ignorance, why it would be okay to have large chunks of the global financial system simultaneously in bankruptcy where the liquidity crunch isn’t just lending costs more and isn’t as freely available, but no lending is taking place at all.
As far as forcing banks to accept TARP money that they did not need (Goldman’s line, I believe), how about explaining why Goldman wanted to be a holding company able to draw on the Fed’s lending facilities? and why Goldman wasn’t the major beneficiary of TARP and the bailout generally when it received billions of federal money that went to AIG and then to Goldman as a bank that had put lots of its pennies in the same counterparty bank? etc.
Regarding Sammy’s point–reduce leverage – reducing loans, is that what you want? Wish Sammy had deliberated this more and provided more food for thought for […]
Linda,
As usual your posts are illuminating and well thought out. If all of that detailed analysis that you have provided was even partly instigated by the comments of Cantab and Sammy then this is the first time that anything they have added to this site has served a useful purpose. It’s always a pleasure to see that someone with significant knowledge is willing to take the time to destroy the stupid commentary of the trolls.
Linda,
Sammy’s faith in banks ability to self-regulate, given the mere 75 years separating the Great Depression from the Great REcession–with the Savings & Loan debacle and Long Term Capital Management debacle thrown in–should stir my soul, I guess.
Banks are very regulated, so where were the regulators for the S&L and LTCB debacles?
I would have loved for some regulator to have stepped in say circa 2002 to 2005 and tried to prevent the Housing Bubble. That would have taken some pretty heavy handed regulation slowing the rise of real estate prices and attendant lending, based on no evidence or political support. In retrospect, it would have been worth it. But I have found no evidence that any regulator or politician that was any more aware of the impending problems than the stupidest, real estate blinded, Wall Streeter. My point about Freddie and Fannie was that here we had government sponsored enterprises, subsidiaries of the Federal Government, that blew their brains out and cost taxpayers more than any other private company, very probably more than all of them combined
Regarding CDSs Cantab, the problem with them is that they were NOT a zero sum game. A million dollar debt had over 10 million of “insurance” on it. Go try to get a million dollars of homeowners insurance on your 100,000 dollar home. ITS ILLEGAL. Not to mention, go try and get insurance on your neighbors home for a million dollars and see if you can collect if his house burns down. This is what was happening in the CDS market and there is a name for it……………….FRAUD.
Jack,
It’s always a pleasure to see that someone with significant knowledge is willing to take the time to destroy the stupid commentary of the trolls.
Whatever happened to “I disagree with Sammy because _______” and then stating your reasoning?
Jack,
Her column was shlect but her response was very good even though she got some points wrong. But it was thoughtfull.
Greg,
I think the derivative part of the transactions were a zero sum game. If one party was gaining the other was losing. However, if the entire market is crashing that has nothing to do with or driven by derivatives.
Sammy,
I’ve run out of patience with both you and cantab, though his comment below yours, “But it was thoughtful,” is out of character and welcome. Generally both you and Cantab have shown very little consideration for thoughtful debate so why would I bother to continue to try same. Linda has more patience and is infinitly more knowledgeable than I on the topic.
Cantab,
Your response is, as usual, self contradictory; “column was shlect” I’m guessing tha you meant shlock. Followed by, “her response was very good” but partly wrong. And yet she was “thoughtful.” Sammy makes more sense than that.
Linda,
We’re just trying to help develop your ideas and present a coherent argument. I’m not going to do liberal but if you are you ought to do it right.
You’re right that we can’t eliminate risk and I don’t see how futures markets increase risk. The only thing I can think or is that derivatives perhaps induced the creation of an oversupply of loans that chased limited quality investment opportunities that caused a price bubble that burst and caused the recession. If this is the case I can’t really blame derivatives.
You really need to explain your theory on how big banks took down the world economy. Is it that they created to much loanable funds that caused the bubble? You can’t just click your ruby slippers three times saying speculation, speculation, speculation and have that pass as scientific analysis for what caused the recession. Securitization actually mitigated the crisis in America (perhaps at the expense to the returns on some Norwegian fisherman pension fund).
Rdan was all wrong as usual when he flew in like batman to defend you. When you blamed republicans by default you said the democrats would do better in avoiding crisis and creating economic growth. Sustainable and equitable growth is for weenies that join cultures that do things like refuse bags in the grocery line. The last time I went to New York and visited the met I benefitted by the funds donated by the oligarchs. My home town colleges do alright also from contributions from the rich.
Flash trading does improve liquidity. Ask the exchanges and they will verify this fact. Flash trading is just another form of arbitrage. Arbitrage is what make markets weak form efficient according to the efficient market hypothesis. Since this activity requires economies of scale by definition it’s a big institution big player game. It’s not unfair, it just that big smart competent institutions do it better.
On Asymmetrical you’re a fine example to be bringing up this point. You spent a large proportion of your life stock piling academic credentials. Do you really think the server as starbucks has the same education as you do? So what are you going to do to eliminate this asymmetry – have a lobotomy?
The Cantab does not switch anything, he just sees you use derivatives as voodoo and tries to give an example that people can understand. Many of your points of view are from ignorance. Do you personally trade in derivatives? Are you a financial economist? If not then where do you get your incite. Please provide a reason why credit default swaps are problematic. In the training that I went through we all were taught that there is a risk that your counter party (ie AIG) might default. Thus, I never understood the reason to bail out AIG since their default was always a possibility.
jack,
Generally both you and Cantab have shown very little consideration for thoughtful debate
Not true. I have given you a template: “I disagree with sammy/cantab because _______”
Somehow, this is too complicated for you, or you cannot fill in the _________. I would guess the latter.
Yes Linda,
That is a very good comment by cantab. ONE OF THE BEST EVER ON ANGRY BEAR. Our challenges are meant to stimulate debate, and I would venture to guess, with no offense intended, that the two of us has had more experience in finance than you have, while you are more accomplished in areas we are not. However, none of us are always right or always wrong, and outsider views are often correct. So let’s toast.
Cantab
A Credit Default Swap IS a derivative! A credit derivative.
http://www.answers.com/topic/credit-derivative
Dont play sloppy with your terminology. Dont remake the definition of derivative to suit your argument.
Both you and Cantab have had your specious arguments critiqued and unravelled here repeatedly, but like the trolls that you are the rebuttals are irrelevant to your intentions. Those intentions are only to continuously throw up smoke screens and straw men. When any point you make is deflected you simply return and repeat the point and state categorically that you are right in spite of having been shown to be deceptive and obscuring of the discussion. You have not intention to have an honest discussion. Through your repetitious distortion of each poster’s commentary you obscure the issues that are brought forward. Yours is just a game with no good intention to focus on a valid argument, but instead to simply fall back on ideology as the proof of your individual points while ignoring all rebuttals. Here’s is a perfect example from Cantab’s diatribe below, “Arbitrage is what make markets weak form efficient according to the efficient market hypothesis.” Efficient market HYPOTHESIS, as though that were an established law of market activities. As though it should be the basis of all market regulations.
In short, you are both a waste of time and bites.
“So let’s toast.” sammy
You are indeed a legend in your own mind. If Cantab’s remark is the best of any thing, it is the art of obfuscation, distortion and ideological screed.
Jack,
I don’t distort or obfuscate and to the degree that you feel my ideology is screed that’s more about your lack of social grace and the fact that you self indulge with the emotion of hatred.
“Don’t ask the barber whether you need a haircut.”
Warren Buffett on bankers’ advice given incentives to place the customer second.
The “notional” amount of derivatives is a gross number that doesn’t net out the long/short sides of the trade and so is much larger than the economic consequences of a portfolio of them.
The homeowners policy analogy is a red herring. Imagine that in addition to selecting whether or not to receive the kickoff, the football team that wins the coin toss also gets the $0.25 coin. The money bet on that coin toss at the Super Bowl is millions more than the economic value of the outcome, but Vegas won’t go under, because Vegas matches its book and takes a fee off of the amount bet as a matchmaker between those who bet heads and those who bet tails essentially not caring on which side the coin lands.
Canada’s banks have much greater concentration than in the U.S., as do Australia. Neither experienced nearly the financial crisis that happened in the U.S.. The U.K. banks are more heavily regulated than the U.S., and have had just as significant, if not worse problems. So “make them smaller” and “regulate them more strictly” while appealing in its simplicity, doesn’t necessarily solve the problem.
Regarding AIG – Treasury determined it was too big to fail. Instead of Financial Products, imagine for a moment that it was their Property Insurance operations that were the heart of AIG’s problems because of an earthquake in NYC. This bailout have been done so that AIG could pay the claims to those they insured, which would have included very wealth property owners who purchased insurance of AIG. So you can take issue with the bailout of AIG (and I have), but once the company was bailed out, complaining that they paid their obligations to Goldman, Morgan, SocGen, etc., doesn’t make much sense.
The analogy between AIG Property and AIG Financial Products is not accurate nor appropriate. As an insurance company, that’s the property insurer, AIG had to meet strict reserve requirements. Property underwriters had to have accurate assessments of the propertys’ values. And generally an individual could only purchase such insurance on a house which he or she owned or rented. A single property did not have multiple contracts written to varied investors. Investing “short” isn’t likely to be possible on property. But AIG Financial Products could write “credit default swaps” with no over sight, with no accurate assessment of under lying risk, with no concern for any actual risk of loss to the co-party to the CDS and with little or no reserves to cover their positions beyond what the value of the entire company might have been.
As an insurance company, that’s the property insurer, AIG had to meet strict reserve requirements.
This is baloney. Accounting regulations (and presumably tax regulations as well) prohibit property insurers from putting up reserves prior to the occurrence of an event.
GEICO does not hold reserves against the potential of each of their insured vehicles being totaled tomorrow, partly because they’re prohibited from doing so and partly because the likliehood of that happening is next to nil.
But the point your making about the difference between CDS and traditional insurance is too literal and moot. Treasury determined that AIG’s bankruptcy would be catastrophic. Firms go bankrupt because they cannot pay their liabilities. Once the decision to prevent AIG from declaring bankruptcy was made, the counterparties to AIGs liabilities were to be made whole. That’s the point of preventing AIG’s failure in the first place.
Sammy:
Insurance has sizeable amounts of reserves to pay off those insurance claims. CDS, naked CDS, Synthetic CDO do not even come close to having similar reserves in hand to pay off reserves. Naked CDS do not even have to have ownership of the bomnd being insured or bet upon. A synthetic CDO is nothing more than a series of CDS tranched into a CDO and insured with another CDS. The daisy chain of passing the buck is long.
If ever anyone wished to identify a Ponzi scheme, CDS is such as there are no or little reserves in hand and the revenue from the CDS is passed to the originator of the CDS and none of the revenue is held in reserve either.
In any case a CDS (derivative) is not insurance in the same mind as the insurance we are more familar with today. The rsult of no reserves to back those CDS was why AIG was loaned $133 billion of $182 billion available to it. To date, we “may” see ~$30 billion back from the sell of overseas assets which will devalue AIG’s holdings substantially.
Sammy:
And $13 billion of those bonuses came from money funneled through AIG.
Jed:
Arguing about paying obligations to Sachs, etc. makes sense in the manner in which it was paid. Did we have to pay 100% of those obligations especially when it is believe they caused the collapse of AIG by calling for more collateral. The percentage should have been smaller.
Jed:
Which is why state pension funds (Virginia and California) saw 40% on the dollar and Sachs and Deutche received 100% on the dollar.
What makes you believe Property Casuality Insurers do not have reserves for future obligations such as claim reserves and unearned premium reserves? Here a litle reading: http://www.aaisonline.com/articles/RealisticResv.html
Ummm m.jed you’re full of crap.
Your coin toss analogy may be the worst ever. The coin toss is based on completely predetermined odds which everyone knows and no one can influence. A coin toss is a completely different type of random event than a loan default possibility but even the possibility exists that EVERYONE betting on the super bowl coin toss bets on heads and if that is the case and the coin comes up heads Vegas loses big time. But you are still talking about a first order event here. The CDSs are a second order event in the worst cases. Two parties who have a debt contract can hedge their losses with a third party for a price. As long as the third party assesses the risk properly it will be priced accordingly. What about when the risk is not known because some information about the debtor is falsified or missing? This is still a first order event and only the amount of debt is being insured. Now bring in outsiders who dont have any skin in the game but simply want to bet on someone elses risk. They enter into a naked contract, often times with the same party that insured the first order contract. Now, the debt is mispriced and the default has doubled in cost to the insurer. This happened not just two or three times to some debt contracts but even more. Plus these contracts were used as assets (they were receiving cash flow from the insurance payments) to leverage other things so no the economic consequences were not MUCH smaller than the notional amounts of the derivative contracts, in many cases the consequences were larger.
Property Casualty Insurers do have reserves for future obligations to the extent that losses have occurred. In limited circumstances they have reserves for expectations of future losses, but an insurer is prohbited from, for example, claiming, “our long term analysis suggests that despite lack of hurricane activity, we on average lose 3% of our premiums in year XXXX, and therefore will post reserves for 3% of XXXX premiums”.
Regarding pension funds – I’d like a citation regarding their counterparty AIG marks. Regarding Goldman and Deutsche, the conversation, I imagine, went something like,
Treasury: “We’d like you to take a haircut”
G/D: “And if we don’t?”
Treasury: “Well we just announced to the world that AIG was too big to fail, so nothing”
G/D; “Okay, nothing it is”.
What you seem to have forgotten is that Blankfein seems to be the only investor invited to the decision making party at the Treasury. You can excuse the results with any interpretation of the facts that you can imagine. The fact remains that AIG Financial Products for some bizarre reason was allowed to bet the bank and take on all contractual requests no matter how ill advised. The results speak for themselves. Treasury, using public funds, made good on what was virtually the worst investment decision making in a century. Counter parties to the bad bet, those on the better side of stupidity, were rescued from a sinking ship that they had a significant hand in capsizing. The entire episode stinks of collusion and malfeasance.
http://www.nakedcapitalism.com/2010/03/guest-post-15-years-ago-the-combined-assets-of-the-6-biggest-banks-totaled-17-of-gdp-by-2006-55-now-63.html
Treasury, using public funds, made good on what was virtually the worst investment decision making in a century.
Jack, this could also describe Fannie and Freddie, subsidiaries of the US Government. AIG guaranteed mortgages, Fannie/Freddie guaranteed mortgages. They did the same thing! AIG bailout = $170B, Fannie/Freddie = $400B. This proves that the Federal Government could have an effective regulator how?
“AIG guaranteed mortgages”
No, AIG did not guarantee mortgages. AIG Financial Products devision wrote guarantee contracts on derivatives of mortgages that were far more difficult to judge for credit worthiness. Worse yet they wrote such guaranty contracts with counter parties that had no interest in those derivatives, but only were placing bets on the credit worthiness of those derivatives. Fannie and Freddie did both, mortgage guarantys and CDSs.
And neither of those companies is a branch of the government. They are chartered by the Congress and are publilc stock corporations. Better yet they were not bailed out to the degree that AIG FP was.