Shouldn’t have let us have anything valuable

Otter : Flounder, you can’t spend your whole life worrying about your mistakes! You effed up – you trusted us! Hey, make the best of it! Maybe we can help.
Flounder : [crying] That’s easy for you to say!

Last week, at his company’s annual meeting, JPMorgan Chase CEO Jamie Dimon let loose with a scalding critique of the Federal government.  As reported in American Banker:

I believed I would be fairly treated by my government

JPMorgan Chase & Co. chief executive Jamie Dimon said during his company’s annual investor day Thursday that he has been turned off by the “capricious, arbitrary and punitive behavior” of regulators since his company accepted $25 billion in aid as part of the bailout of the financial industry in 2008.

Ever since the global capital crunch, we have seen periodic outbreaks of irrational populism.  It’s understandable, of course – finance is abstruse, bankers make money and therefore are easy targets, and elected or appointed officials sometimes find it convenient to flog a helpless whipping boy, such as the absurd spectacle of Congress seeking to overturn AIG executive bonuses payable to the people who would be disarming the latent financial bombs left over from the crunch.  Meanwhile, in a classic case of “do as I say, not as I did”, the government was promulgating executive pay rules that it proposed to apply to anyone whom it did not need, and to exempt from anyone it did. 

“We think to this of this, gentlemen, as a line-up“

Even the President has occasionally lapsed into illogical populist language, justifying a proposed new tax with the specious sound bite ‘we want our money back’ … at a time when the government had already been repaid.  Indeed, the government has generally reaped net profits from the TARP repayments, via not only the dividends but also the buyback of the mandatory share options.

Even more bothersome to Mr. Dimon was the implied libel on his bank for having taken TARP in the first place:

While the company has since returned that aid with interest, JPMorgan Chase has been lumped in with all of the troubled institutions that may have acted irresponsibly in the run-up to the financial crisis, Dimon said. It is also facing a slew of new accounting rules, federal fees and other regulatory changes that could sap its bottom line.

As I’ve posted before, government and capital have asymmetric doomsday devices. 

Ze are zo many zings a goffernment can do

Government has the sovereign power, which inherently cannot be bound, so that government can if it chooses abrogate contracts with relative impunity, or repudiate its debts via sovereign bankruptcy, or more subtly, it can devalue its currency through inflation, the young’s revenge on the old for their previous profligacy.

Capital can flee, faster than government can grab it.

This is how much we’ll put at risk on your integrity

Economies work – and therefore nations work – when capital and government each see the other as a reliable counterparty operating according to consistent rules of long standing and with a shared interest in maximizing the common wealth.  It’s quite clear Mr. Dimon doubts the government’s integrity:

If he could do things again, Dimon said: “I don’t know if I would” accept aid. “But then again, when you are in that situation, and your country calls, it’s hard to say no.”

It wouldn’t be hard for him to say No now; in fact, his stockholders would probably demand it as a matte of his fiduciary duty.

At the least, he said, he would have tried to find some way to avoid the “vilification” that came from accepting federal aid. 

Good luck, Mr. Dimon; the sovereign cannot be bound.

So I discovered

When Dimon speaks, though, the Administration ought to listen:

Dimon has assumed the role of the country’s most credible banker and outspoken banker since JPMorgan Chase has emerged from the recession as perhaps the healthiest and most powerful commercial bank in the U.S.

“I didn’t have to be here, you know”

For that matter, the world ought to listen, as Mr. Dimon’s additional remarks echoed AHI’s concerns:

“We want to see employment go up consistently for several months,” Dimon said. “If we’re lucky, it will happen some time this year.”

Unfortunately, the global recession will linger like a bad cold.  The stimulus legislation hasn’t stimulated; if anything, it’s impeded economic recovery.

The company doesn’t expect to lose a lot of money should interest rates rise, as it has been focusing on reducing its rate exposure. 

In other words, Mr. Dimon is taking out insurance against Ben Bernanke raising rates – which of course he must and he will – and against inflation coming back.

A 100 basis point increase would translate into a $500 million loss, which he described as “mostly noise in our company.” 

He’s also hedged JPMorgan’s sovereign exposure elsewhere:

JPMorgan Chase also doesn’t have a lot of exposure to the debt woes plaguing Europe. “Greece itself wouldn’t be an issue for this company. Neither would any other country, in my opinion,” Dimon said. 

If anything, Greece’s troubles – and those right behind it of Spain and Italy, much larger economies – will sink the Euro, not the dollar.  Which is why the Euro’s suddenly in free fall.

No worries, Europe

He said JPMorgan Chase is actually more concerned about California’s deficit troubles, which could actually pose a higher default risk than the sovereigns in Europe.

Of course – because not only is JPMorgan all over California, California’s part of America, so that if California collapses – a bleak prospect looking more likely with each passing day of inaction – then the American economy will have another infection to fight off.

Mr. Dimon, therefore, is keeping huge capital reserves:

Dimon said the company also has no timeline for winding down its $40 billion in loan-loss reserves, which some industry watchers say could deliver a jolt to earnings in coming years.

I like being protected from a very rainy decade

In other words, the analysts believe that JPMorgan has over-reserved against loan losses, meaning that at some future point, JPMorgan could boost its earnings by deciding that it had previously been too conservative.  Such moves verge on ‘earnings management,’ if they are used to manipulate results and game bonus formulas rather than as exercises in disinterested judgment.

He said the bank’s reserves should be considered some $10 billion to $20 billion of excess capital that it will have at its disposal when things improve. “We’re going to keep them as high as we can keep them,” he said. “We think it protects the company.”

There’s another way to view those reserves – as a cushion against government unreliability.  That’s a lot of capital to sit on the sidelines because government has proven itself unreliable.

And let there be no mistake: having once been burned – as the bank sees it – by trusting government, it is fully ready not to trust again:

Regulatory pressure is another issue, [Investment banking division head Jes Staley] said, although the company is confident it can thrive in the face of any regulatory changes as long as they impact the industry equally.

Staley will play on any field that’s level

Hear the fear?  With the government not just regulating markets but owning large chunks of industries, it is easy to see government self-interested motivation behind its actions.

JPMorgan will also pass onto customers higher funding costs that may result as tighter regulation.  “We’re going to reset the price of credit globally, and in a dramatic way, if the regulators go beyond the bounds that they should,” Staley said.

That, my friends, is an unmistakable threat – and should be heard as such. 

You really want to take us on?

Altogether this is a totally damning report card on the state of governmental integrity:

Flounder : Will that work?
Otter : Hey, it’s gotta work better than the truth.
Bluto : [thrusting six-pack into Flounder's hands] My advice to you is to start drinking heavily.
Otter : Better listen to him, Flounder, he’s in pre-med.
D-Day : [firing up blow-torch] There you go now, just leave everything to me.

Why am I not confident?

They’ve lied and used me every time … maybe this will be different!

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[Continued from yesterday's Part 1.]

Yesterday’s post opened the topic of compensating investment bankers and a fortiori investment banks as well, taking as initial text Steven Brill’s New York Times profile of TARP paymaster Kenneth Feinberg. 

Put up your dukes, Feinberg!

Brill is full of admiration for Feinberg’s jawboning down the bankers’ actual paychecks, and pays much less attention to the negotiations also taking place about structure, contenting himself with superficial rhetoric questions like this:

When governments intervene to impose taxes or put limits on bonuses, for example, companies tend to increase salaries or introduce new perks. When the issue is left to the companies’ boards, endless questions peck away at the seemingly simple idea of paying executives based on performance. If pay is based on what an executive’s peers at other companies get, how is a peer group defined? Why penalize and demoralize talented employees if the firm’s stock or profits are down because the economy as a whole collapsed, or because the company incurred a short-term loss while making a sensible long-term investment? Besides, as a general matter isn’t it just plain silly to worry about spending a few extra million to keep the leaders at the top happy when they’re making decisions with billions at stake?

We, on the other hand, are made of sterner stuff.  Yesterday we covered three ideas:

1. Align time horizons between bank earnings and pay.

2. Measure the right metrics of financial performance.

3. Align incentives in payment formulas.

Want to try any of these?

Today we have three more, and we can dig into the reasons why what we’d like to have happened hasn’t happened yet.

4. Match compensation structures to newly invented risk slices

In my world, some people are paid on an eat-what-you-kill basis — their compensation is entirely contingent on them delivering something.  Normally this is applied to commission salesmen, but if the payment is in cash, we get back into the agency risk associated with bad lenders and bad loans.  And that doesn’t work at all with investment bankers and financial product designers.

Or does it?

You’ve won – aren’t you happy?

It’s common enough in securitization for the originating bank to take the majority of its compensation in the last tranche – the B piece or C piece that is left over after the senior pieces have been sliced off and sold.

What are those tips worth?

If the loan pool performs, quite a lot

There’s a certain Willy-Wonka justice in all this; if you’re paid in parts, and the parts is rotten, then you get the indigestion.

Gloop!

This can actually be done, and without too much complexity.  Any time an activity adds value by creating a new commodity, pay the creator with a piece of the commodity.  Land developers have been paid in lots (no less than Frederick Law Olmsted was once so compensated), sharecroppers in a portion of their grain, and hedge fund managers in a portion of the yield earned on their investments. 

Willing to be paid in kind: Olmsted in 1857

If derivatives, CDS’s, CDO’s, and so on, are such great investments, create a tranche reserved for the managers, and preclude its sale for several years – at least through the seasoning period.

This one has been properly aged

For instance, consider this structure used at AIG:

My friend (who did not want his name used because, he says, “being associated with AIG is not safe for my family”) is a mild-mannered math whiz who worked at a unit of AIG Financial Products that, he says, had nothing to do with the small London-based credit-default-swaps group that sank the company. Over the last half-decade, he made millions every year from a bonus pool composed of the profits supposedly made by Financial Products.

But he had to leave roughly half of his bonuses in the pool for five years so that the payouts could be adjusted for any subsequent gains or losses from Financial Products’ trades. (That’s an extreme version of what’s called a “claw back,” another reform that Feinberg’s guidelines would require.) When the credit-default-swaps unit went bust, he personally lost tens of millions in that pool. (Which would also mean that he took home tens of millions over those five years.)

Observe that this structure was already in place at AIG, and yet AIG is the sickest of the sick:

5. Mandate risk disclosure

“Let’s face it – this isn’t the worst thing you’ve caught me doing.”

– Tony Stark, aka Iron Man

Nothing to worry about here

If we cannot forbid risk-taking (and we can’t), and we want to enable the market to innovate (and we do), then investment banks will always be taking risks.  But we ought to know what they are, oughtn’t we – particularly if public companies are involved?

So much sense does this make that we’ve been trying it for years, ever since one of the last decade’s biggest invisible stories, FIN 46, which sought to compel risk transparency and became so entangled with complexity as to render the original purpose unachievable … and worse, clouded by the misapprehension that it was working, when it wasn’t.

“Respondents were consistently incisive, reproachful and vehement in their criticism of FASB’s year-long process of developing and vetting FIN 46, conveying in strong, pointed language their dissatisfaction with FASB’s responsiveness to the securitization market and their disappointment with the final Interpretation, which many construe as an overly broad, ‘over-reaching’ measure which is treating a very specific abuse (inadequate and misrepresentative corporate disclosure).”

As you can imagine, this led to contortions by which entities sought to avoid having to consolidate.

A total of 470 participants from the US and Europe participated in the survey. Most also felt that the market will adapt itself with new structures which simply cosmetically re-engineer SPEs to fall out of the definitions of the Interpretation.

That was the invisible story.  FIN 46, which sought to make things more transparent, in fact made them more opaque.  While investors basked in the illusion of transparent consolidation, in reality they were absorbing ever more risk.

Aftermath.  FIN 46, now renamed as FAS 167, is now a permanent part of the landscape, but the puzzles it poses remain unsolved.  Consolidation is still a bete noire in accounting and CFO circles.

You still haven’t dealt with me

6. Regulate the ability of publicly-traded entities to take on financial risk

In the first possible principle, I suggested aligning the time horizons of managers and financial counterparties – lenders, equity investors, and stockholders.  Yet that principle – enforced financial partnership over long intervals like multiple years – is antithetical to another principle on which our equity markets are founded – namely, liquidity. 

Anyone who’s ever owned a publicly traded stock knows that markets move fast – much faster than government — and that they are constantly incorporating new information, sifting it in a marketplace of ideas whose aggregate expression is a single number, the price of the last stock trade.

How the markets keep score

Yet markets are notoriously inexpert in pricing abstract risks, new risks, and low-probability ‘black swan’ risks.  In fact, everything about the publicly traded company discourages taking the long view.  Moreover, corporations that trade in the public markets are by definition taking vast sums from ordinary investors – and when these publicly-owned companies go upside down, Joe Sixpack gets hurt … which means Uncle Sam rides to his rescue, with costs and consequences for all of us, as we’ve seen with the bailouts of numerous companies, mostly questionably GM and Chrysler. 

Remind me what public purpose we served by putting money into GM?

There is a solution to the challenge of public companies taking on risk – make them collateralize it.  Already, regulated financial institutions are required to maintain particular capital ratios, under both Basel II accords and FDIC/ Treasury/ OCC rules – and these, in turn, are tied directly to the assets on their balance sheets, as valued under FAS 157 or otherwise.

In a world where every financial institution is effectively a bank, and every bank is a Bank of Glass, one could assign to every financial instrument a risk assessment (even a crude metric would do), and then require that the issuing institution hold in high-credit liquid instruments (e.g. Treasury bills) capital equal to the total assessed risk.  In effect, this would institutionalize and automate the post-TARP stress-testing done to the TARP recipients. 

There’s our six options – sensible, right?

Well, some of them are silly

All rights, that’s too silly

Now, finally, we can settle down with our fat Steven Brill article, and discover the four big reasons why it’s hard to implement any of the compensation structuring reforms just presented.

[Continued tomorrow in Part 3.]

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With the economy in the tank and banks (including the Federal Reserve) making record profits, populist ire has settled on the bankers themselves.  

Were you paid a great deal of money?

Yes, we … uh …

Guilty!  Until proven innocent!

Deservedly so?  That question is implicit in a lengthy Steven Brill piece in the New York Times, a largely sympathetic profile of TARP paymaster Kenneth Feinberg.  Brill makes much of Feinberg’s flagellating bankers, as others are lining up to take their turn.  The bankers are facing a financial crisis tribunal and being bashed by the President:

“Those who oppose this fee [The proposed $90 billion tax on all banks – Ed.]  have also had the audacity to suggest that it is somehow unfair,” President Obama continued, “that because these firms have already returned what they borrowed directly, their obligation is fulfilled.”

(How naively audacious I am, to think that repaying a debt ends the obligation.)

Next you’ll be telling me I can get it from a tap

Some of the shots are truly deserved, as when Goldman CEO Lloyd Blankfein walked into a verbal door:

You mean you open it first?

Testifying to the Financial Crisis Inquiry Commission, the body established by Congress to determine the causes of the Wall Street debacle, Lloyd C. Blankfein, the chairman and chief executive of Goldman Sachs, drew most of the fire.

Mr. Blankfein parried repeated questions over his bank’s extraordinary profits and salaries. At one point, when he likened aspects of the financial crisis to a “hurricane” and similar acts of God, the commission’s chairman, Phil Angelides, a Democrat and former California state treasurer, cut in to say, “Acts of God, we’ll exempt. These were acts of men and women.”

Score one for Chairman Angelides!

How do you like me now?

Curiously, the vituperation coalesces around individual bank executives in ways that it does not around either elected officials (Senator Ben Nelson) or popular figures.  Simon Cowell, Jay Leno, Tiger Woods, and Conan O’Brien – to take four famous names currently in the news – all make more than these vilified industry titans, yet attract none of the vitriol. 

Actually, he makes more than I do

Perhaps that’s because the only time one knows a banker’s name is when the banker is spotlighted in the pillory.

Who makes more than I do?

Pre-divorce or post-divorce?

Nevertheless, all this editorial and populist ire now being directed at individual bankers, while fun and distracting, obscures the real issue – how should financial executive pay be structured?

Remarkably, even though the inquisitive Brill devotes 8,500 words to just this topic, he treats it as a clash of Manichaean personalities, and the structural question comes up only tangentially. 

How people are paid at the top in a free-market system has always been a contentious issue, especially in bad times. Babe Ruth’s most famous quip was not about baseball but about salaries. When asked in 1930 if it was right that he should be making more money than President Hoover, he replied, “I had a better year than he did.”

My performance can be measured – can yours?

Let us go then, you and I, when the payment is dividing up the pie, and lay out some principles that ought to govern financial-executive pay.  For today, we will take refuge in passive-voice verbs, focusing on what should be done – Parts 2 and 3 of this post will be time enough to explain why the laudable principles I’ll espouse below will be so hard to put into practice, even as it was during Mr. Feinberg’s fiat.

I’ll solve the executive pay problem – flog them

What should be done?

1. Align time horizons between bank earnings and pay

Virtually all financial products, whether debt or equity, involve a trade over time: I give you money today, you promise to give me money tomorrow.  That’s a temporal mismatch, and is why the risk curve and the yield curve have similar shapes – the future is inherently uncertain, and the further one looks into the distance, the more uncertain.

The timing mismatch becomes even more challenging when applied not simply between the independent parties who constitute buyer and seller of a financial product, but also between the employer bank and the employee executive.  In terms of the cash transactions, banks as institutions are normally in the position of putting the cash out, hence taking the long temporal risk.  If they then turn around and pay their executives short, giving them compensation in unrestricted cash, the temptation to see the future too rosily – and turbocharge the balance sheet – becomes well-nigh irresistible.

I can resist anything … except temptation

If one is going to pay bankers huge sums, one would like those sums to vest only over as many years as the risks surface (or don’t).  We can accomplish this in several ways:

Escrowed bonus payments that cannot be cash for several years.  (These golden handcuffs also encourage executive loyalty, which is usually a good thing even if it discourages labor mobility.)

Payment in restricted stock.

Payment in options, which are even less tangible than restricted stock.

It should come as no surprise that deferred-payment approaches figure prominently in the recommendations of advocates for executive-compensation reform like Lucian Bebchuk.

Bebchuk bewares short-term thinking

2. Measure the right metrics of financial performance

Any punter knows that at the track, placing a bet is not when money is made; winning the best is the moneymaking events.

Has anybody made any money yet?

Whenever transactions involve a time element, money is earned over the entire time period, even if the cash is realized only at discrete intervals.  That ineluctable fact was the motive force for inventing accrual-basis accounting, which is itself an enormously potent force, fully as destabilizing as the modern inventions of securitization, CDO’s, and credit default swaps (CDS’s).

With accrual-basis accounting, the question of when money is earned becomes at some level metaphysical.  Think of cash-basis accounting like a train entering and exiting a tunnel: we see money go in, we see money come out.  In between all is darkness, so who is to say when and where the train has moved?

Fred, Sam, what did you earn, and when did you earn it?

Accrual-basis accounting imagines the train’s progress through the tunnel, as if the walls were transparent.  It is unknowable, but that does not prevent accountants from arbitrating – and their answers have force,  because what the accountants bless becomes ‘earnings,’ as good as money as Yogi Berra would have said.

As we’ve seen, if you measure by earnings, and management controls earnings, then management is motivated to game the bonus formulas by fiddling the earnings.

Keeping score solely by cash is no panacea either, because banks can reverse the flows – attract cash by offering (say) very high depository rates.  Many is the business that front-ended its cash (imagine a magazine subscription where you pay up front for a year’s issues) and then left its customers high and dry (the prepaid cruise that never left the dock).

If earnings or EBITDA are not the answer, then what is? 

You’re not allowed to wriggle away from the tough question

3. Align incentives in payment formulas

It’s all well and good to suggest that incentives be aligned via payment formulas, but via what equation or algorithm?  If we can’t agree on the right metric of financial performance

One proxy often suggested is stock price, but as we’ve seen with CDS’s and bear raids, this too can be stressed and pressured – especially in the short run. 

Incentive alignment is a stumper. 

Better keep reading, Captain Marve4l

What about our next approach?

[Continued tomorrow in Part 2.]

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Yesterday we met beleaguered Treasury Secretary Tim Geithner, the Administration’s point person on comprehensive post-catastrophe fundamental financial and regulatory reform, who having attained a position of power finds himself opposed not by his enemies but rather by his ostensible friends, his frustration boiling over as reported in the Wall Street Journal:

“You won’t like me when I’m angry”

Neal Wolin, Treasury’s deputy secretary, said Mr. Geithner told regulators “they have the prerogative to express their views, but he wanted to make sure that, since everyone had agreed on the importance of achieving reform this year, everyone stayed focused on that goal.”

From that little phrase one can deduce much about Mr. Geithner’s administrative reform strategy, and where it is foundering.  While the Journal’s article focused almost exclusively on the regulatory infighting rather than the substance, here in capsule form are the core elements:

The government’s proposal would empower the government, among other things:

[1] To take over and break up large financial companies

[2] To merge two bank regulators

[3] To toughen oversight of mortgages

Obviously Mr. Geithner convened all the lesser barons, with President Obama hovering as a looming authority figure, and swore them collectively to this vision of comprehensive financial reform (that I believe will necessarily create the Bank of Glass).  Each participating bureaucratic laird so swore, right hand figuratively upraised, left hand behind his or her back, fingers crossed.

Government officials said Mr. Geithner had expected regulators to object to parts of the plan that threatened their power or authority, but Treasury officials appeared caught off guard at how much the criticism resonated with lawmakers.

It’s called ‘lobbying’ and its mother’s milk, ‘political contributions.’

“I swear allegiance, to myself, and to my re-election chances”

Mr. Geithner wanted to tell the attendees they shouldn’t let turf battles get in the way of fixing a system that is clearly broken, Mr. Wolin said.

I’m cutting through the muck whether anyone helps me or not

He declined to comment on Mr. Geithner’s tone and language.

We’re declining comment on the language

Mr. Geithner’s tone is a consequence of the inevitability effect, and the role in which he has been cast – the driver:

 I’m not stopping until you’re all moving

When a proposal becomes conceptually inevitable, all the stakeholders instinctively migrate into one of five roles.

1. The driver(s).  The person or group compelling the activity forward.  The driver, a visionary, sees riches and demons no one else sees.  As such, he is single-minded: close. 

2. The suddenly sober.  They were joking around, playing the usual games, when suddenly the driver flung down the talisman of doom – and they realized, whoa, this is serious.  And they did the right thing.

3. The Laocoons who want to win the recriminations.  Realizing they are going to lose, they intend to make very clear they had no part of it.  They may be wrong-headed but they are honorable and direct.

4. The reluctant bargainers.  They didn’t want it, but now they realize that train has left the station.  Having lost the war, therefore, they want to win the peace, or at least get a piece of the win. 

5. The running-board scramblers.  They weren’t necessarily going to push this car out of the muck, but once the wheels start rolling, they want to throw their piece of policy luggage on board.

Within the reluctant bargainers I should have identified a further subset – the empire-builders.  Any time power is being centralized, any administrator worth her salt wants to increase her power, so if he’s in the likely centralizing agency, she’s all for standardization and consolidation, and if she’s out, it’s all about ‘checks and balances.’

With that in mind, turn with us now to Mr. Geithner’s verbal woodshed and listen for the participants’ positions to reveal themselves:

“You are talking about tremendous regulatory power being invested in whatever this entity is going to be,” Ms. Bair told the Senate Banking Committee last month. “And I think, in terms of checks and balances, it’s also helpful to have multiple views being expressed and coming to a consensus.”

When the Federal Reserve Board of Governors sets rates, that board debates and votes.  So that process already works.  When Ms. Bair, who is not on the Federal Reserve Board, speaks of “checks and balances,” one can safely read that as “I’d like a veto over Fed decisions.”

All of your decisions, that is

Officials from the Federal Reserve and the Office of the Comptroller of the Currency, meanwhile, have questioned the creation of a new federal agency to oversee consumer regulations, a move that would take away powers from both institutions.

Let me join them in shuddering.  Consumer risk exposure is not greater in banking than any other sector of the economy, nor is protection of bank consumers intrinsically a financial-oversight role.  Since banks are stores where people entrust money, bank regulation should be about assuring that money’s safety.  Consumer protection isn’t unique to banking, nor intrinsic to it.

Administration officials say they aren’t worried about the overhaul’s prospects –

What else would they say?

– adding that there is consensus on key aspects, including the regulating of over-the-counter derivatives.

That’s merely agreeing to the obvious.  Obviously we now need some levels of derivative regulation – but by itself that says nothing.  What matters is whether the regulation is disclosure, minimum capital requirements, or approval, and if so in what form and by whom, which is the enormous political-turf question.

We definitely agree there’s some manure to slice up

Treasury officials say they expected a big debate over the complex legislation.

O those seers, who are so wise in the ways of Washington.

The first piece, which addresses executive pay, passed the House Friday.

That’s just the low-hanging political fruit, and the non-contentious element.

“The industry is already back to their pre-meltdown bonuses,” said White House Chief of Staff Rahm Emanuel.

Remember, Mr. Emanuel is sound-biter-in-chief for the President.

Sound bites?  Ho hum

“We need to make sure we don’t slip back to risky behavior where the institutions have all the upside and the taxpayers have all the downside, which is why we need regulatory reform.”

That’s well said, and it’s the core issue.  When agents have upside without downside, and principals have risk, then we get bad lenders making bad loans, GSEs overlevering themselves, and a host of financial implosions.

Plenty of turf for all of us

At a House hearing last month, Mr. Geithner said it was “perfectly reasonable and understandable” that different federal agencies would balk at giving up powers. “Frankly, all arguments need to be viewed through that basic prism,” he told the House Financial Services Committee.

In many ways our current banking regulation operates like the Articles of Confederation, where each regulator is akin to a sovereign state that can safely ignore what the others are doing, and may certainly ignore the dictates of any purported central regulator.  Now what Mr. Geithner wants is to force through a new federal financial Constitution that makes the Federal Reserve the truly national supra-regulator:

The administration’s proposal would give the Fed broad discretion to supervise any major U.S. financial company and would also create a “financial services oversight council” to coordinate policy and help resolve disputes among regulators.

One ring to rule them all, one ring to bind them.

One conference table to seat them all …

How power would be balanced between the Fed and this entity has emerged as a flash point, one that administration officials debated.

Ultimately, officials felt the regulatory structure needed a single point of accountability –

Instinctively I think that’s right.  Today capital is at least national; banks are national; financial markets are wholly national.  Regulators must always have a breadth of sweep as large as the markets they seek to regulate, otherwise the markets will flow to the boundaries just outside the unfavorable regulatory environment, and will arbitrage the differences between those environments.

If only I coulda got across the state line …

– arguing that one weakness in the government’s response to the financial crisis last year was clarity over which entities were in charge.

Correct; it was.

The administration has pushed for Congress to complete the overhaul by the end of the year. House Financial Services Committee Chairman Barney Frank (D., Mass.) and Senate Banking Committee Chairman Christopher Dodd (D., Conn.) have both said that remains the goal.  Both men, however, have suggested the overhaul could change …

Translation: we’re completely with you … sort of.

The top Republicans on these committees, Sen. Richard Shelby (R., Ala.) and Rep. Spencer Bachus (R., Ala.), have also expressed skepticism over ceding too much power to the Fed.

“A rush to judgment where they basically throw these things together without any consensus is going to be a disaster,” Rep. Bachus said.

That’s never stopped us before.

And look how well it worked

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Turning slabs of excreta into regulatory fuel

In any new or emerging sector, business innovation always outpaces regulation – experimenting with giddy speed and venturing into that free libertarian space which sounds idyllic until the snakes of corruption slither in. Decadence and wild excess ensue, which is fun when it lasts, and then the world gets the mother of all risk hangovers. This financial catastrophe is the precondition to fundamental financial and regulatory reform, at which point enters the architect of new regulation – in this case, Treasury Secretary Tim Geithner, who’s been the Administration’s chief designer of a macro-level regulatory structure.

It is a job both thankless and pressure-packed, leading to the frustration recently chronicled in the Wall Street Journal:

WASHINGTON — Treasury Secretary Timothy Geithner blasted top U.S. financial regulators in an expletive-laced critique last Friday as frustration grows over the Obama administration’s faltering plan to overhaul U.S. financial regulation, according to people familiar with the meeting.

‘Expletive-laced’ is a phrase few would associate with our mild-mannered Treasury Secretary. What could so fray his nerves?

Read my Anglo-Saxon, polysyllabic lips

While it may seem trivial gossip, I suspect that underlying it is a much deeper structural concern – namely, that creation of a newer holistic and coherent financial regulatory architecture is in jeopardy, not from its enemies, but from the inevitability effect on its friends.

Mantra for a reformer: beware the inevitability effect

As Dwight Eisenhower said, If a problem cannot be solved, enlarge it. Every time business expands its reach, regulation must follow. Now capital is at least national if not global, money is stored in computers not vaults, and what constitutes a financial institution has morphed beyond the capacity of post-Glass-Steagall regulators even to envision.

“Do I really have to sign this?”
President Roosevelt flanked by Glass and Steagall

In a post-physical banking world, it makes no sense whatsoever for financial entity regulation to be narrow-limited either in geography or in ecosystemic niche. Instead we must create the Bank of Glass, which I prophesied last summer:

Transparent scalable granularity

What is it and why do I want it?

Market investors want three things:

1. Transparency. If opacity leads to fragile balance sheets, then transparency creates strength. Tomorrow, the price of doing business will be an open-book acceptance that investors have the right to look anywhere they want, any time they want, and ask any question they want about the holdings.

People who bank in glass houses, know what their positions are

2. Granularity. What got Wall Street and its customers into the self-reinforcing-writedown cycle was aggregation, slicing, and the resulting loss of information.

Information is granular, in Wall Street parlance, when there is a clear and complete chain of numbers from the smallest bit of data to the largest aggregation – when, that is, aggregating entails no loss of information. This implies a ‘custody chain’ whereby all information gathered at one end of a financial structuring chain (the capital consumer) is fully accessible at the other end of the chain, the capital provider or long-term asset holder.

3. Scalability. Capital providers and capital markets demand scale, which demands standardization and consolidation.

If you want a metaphor for post-Bear reporting, imagine Google Earth.

Everything from here is just detail

Life in a glass bank

However this market chaos shakes out, when it stabilizes, there will not only be new and stricter rules from regulators, reporting requirements will render the data-opaque brick bank a thing of the past. Only via full transparency will those who want to grow their portfolios or businesses be able to regain the trust – and the money – of the capital markets.

To tap capital, we will all have to live in financial glass houses, where everything we own, everything we do, is on display all the time.

Over-arching regulation unifying all financial institutions and all financial products whether direct or derivative will require a grand unified theory of banking, observed by all banking regulators overseeing all financial institutions.

Wouldn’t it be nice if banking regulators were treed together?

This problem would be hard enough if starting from a clean slate; it is made harder for regulation because every initial regulatory framework is at best a patchwork quilt. At worst it’s a realm of feuding fiefdoms, where each established regulator enjoys its local sovereignty and zealously guards its prerogatives. Each regulator’s turf-protectiveness works against the larger goal.

You really think I’m interested in dissolving my autonomy?

Just as the Articles of Confederation proved unworkable when the newly independent nation was faced with an interstate challenge (Shay’s Rebellion), the absurdly Balkanized US financial regulatory structure was completely exploited by a dizzying pace of derivatives piled upon securities and pureed through tranches.

And in the end, who knows what it was?

The United States has a patchwork quilt of regulatory bodies, dating back to the Jeffersonian phobia of capital, and means, as I wrote nearly a year ago, that the emerging new regulatory framework must be larger and more expansive:

This story – that Congress drove us into excessive lending – is gaining wide circulation among the financial sector’s libertarian and conservative fraternities. I think it completely reverses causality – the banks betook themselves into the space in pursuit of quick profits – but its dismantling would take us away from the theme of this post.

While it will be painful, the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence.

The inadequate and multiply-provincial regulatory system we now have must be superseded by an integrated new framework, which requires a principal designer, for which position Secretary Geithner has already been chosen:

The proposed regulatory revamp is one of President Barack Obama’s top domestic priorities. But since it was unveiled in June, the plan has been criticized by the financial-services industry, as well as by financial regulators wary of encroachment on their turf.

It would take too much time (for me to figure out and for you to read) to dissect the particulars of each proposal, many of which will change anyhow before they are implemented.

No point in dissecting it if it’s dead on arrival?

Instead, keep your eye on the macro principles, which are these:

1. Everyone is a bank. By any other name – even a Wal-Mart ATM in a grocery store – if it takes deposit-like inflows and provides credit-like outflows, then it is a bank.

2. Everything is a financial instrument. If you buy or sell it in the money store, it’s a financial instrument.

3. Everyone is a Bank of Glass. You get up to hijinks between closed doors, you lose your privacy privileges. All financial institutions depend, directly or implicitly on the state’s balance sheet to backstop their actions. The state having discovered that even unregulated entities can make gargantuan horribly overleveraged bets, the state will now insist that everybody sleep with the lights on.

4. All banks and all financial instruments are capital-charged with the originator having hard equity at risk. I’ve pointed out before the concentrating effect of having hard equity at risk. The way to compel this is via capital charge. (The parallel here is with regulation of psychotropic drugs. When they were naturally grown, they were free and legal; as they became more refined, poppies into opium into heroin, they became first regulated and then criminalized. The same goes for psychedelic financial instruments, man; far out.)

Wow, man, derivative

Nothing sobers up a risk-taker like having his own money permanently in the transaction. Expect heavy capital charges – probably excessively weighted for a while, but that will be better than the unbearable lightness of B-piecing.

5. All professionals are licensed. So we license the mortgage brokers; we intermediate the home appraisers. We’ll clamp down on originators, standardize disclosure documents, improve consumer protection (via disclosure, not a new super-agency, please), and generally put everyone through a series of road tests.

Secretary Geithner has to know all this; he’s known it at least for a year, probably for several years. Now, having migrated form the relative obscurity of the New York Fed to the spotlights of Treasury, he must have expected that his control over the levers of power would enable him to force through logical change.

No such luck.

Can’t find your way out of committee?

Larry Summers, who preceded Mr. Geithner as Treasury Secretary and who now glowers in friends-close proximity to the President, was massively unable to pull Harvard together out of its entrenched fiefdoms. He failed because each graduate school faculty has its own budget and endowment and donor base. That money power enabled them cordially to invite the Harvard President to go pound sand. Unable to compel, and likewise unable to require, Mr. Summers was emotionally incapable of persuading.

Mr. Geithner, who is smoother, has evidently been trying the route of persuasive pressure, only to find that appointed officials have a similar power of veto:

Mr. Geithner told the regulators Friday that “enough is enough,” said one person familiar with the meeting. Mr. Geithner said regulators had been given a chance to air their concerns, but that it was time to stop, this person said.

Oooh, I love it when you talk ultimatum.

Whom was he lecturing?

Among those gathered in the Treasury conference room were:

Federal Reserve Chairman Ben Bernanke

Securities and Exchange Commission Chairman Mary Schapiro

Federal Deposit Insurance Corp. Chairman Sheila Bair.

Grasping? Turf conscious? Me?

In addition to Mr. Bernanke, Ms. Bair and Ms. Schapiro, other attendees at Friday’s meeting were:

Fed Governor Daniel Tarullo

Comptroller of the Currency John Dugan

Commodity Futures Trading Commission Chairman Gary Gensler

Office of Thrift Supervision Acting Director John Bowman.

Regulate him, not me

Spokespeople for all regulatory agencies represented at the meeting declined to comment.

There being no upside whatsoever in doing so …

Friday’s roughly hour-long meeting was described as unusual, not only because of Mr. Geithner’s repeated use of obscenities, but because of the aggressive posture he took with officials from federal agencies generally considered independent of the White House.

See, that’s the problem – they are independent of the White House, and have always been. Independence of central bankers is a cornerstone of modern economic policy, so much so that promptly upon Gordon Brown’s becoming Chancellor of the Exchequer, he immediately granted independence to the Bank of England.

Mr. Geithner reminded attendees that the administration and Congress set policy, not the regulatory agencies.

“Remember, I’ve been appointed already, your appointment’s still coming up”

Dangerous ground there, and an inflammatory statement. Independent agencies have their freedom for a policy reason – not to kowtow to the current prevailing winds is intrinsic to their value. Contradicting that premise could easily offend listeners and harden their skepticism into opposition.

Mr. Geithner, without singling out officials, raised concerns about regulators who questioned the wisdom of giving the Federal Reserve more power to oversee the financial system. Ms. Schapiro and Ms. Bair, among others, have argued that more authority should be shared among a council of regulators.

I think it was Abraham Lincoln who remarked that he never posed strategic questions to a council of generals, because their consensus bias led them always to counsel caution. Shared authority is divided authority – good, maybe, for deliberative bodies (like a Congress); bad for executive and administrative ones.

“If you need my consent, baby, you’ll wait until I’m ready”

[Continued tomorrow in Part 2]

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