Did Sheila Bair Save the U.S. from Complete Financial Meltdown?

When a moderate (meaning anachronistic) Republican proves to be a more tough minded regulator than Democrats, it serves as yet another proof of how far the county has moved to the right. Bair, in a long “exit interview” with Joe Nocera, says a number of things that would have been regarded as commonsensical and obvious in the 1980s, yet have a whiff of radicalism about them in our era of finance uber alles. For instance: Bear should have been allowed to fail, TBTF banks are a menace (well, she doesn’t say that, but makes it clear she regards them as repugnant), bank bondholders should take their lumps.

Bair was alert to the dangers of subprime, having recognized how dangerous it could be in the early 2000s (when a smaller version of the market blew up, taking homeowners along with it), and was not a believer of the Paulson/Bernanke party line that subprime would be “contained”. She long championed mortgage mods as better for lenders, borrowers, and the economy, and has fought an uphill battle with the Administration on that front. With the IndyMac failure, which put the subprime lender/servicer in the FDIC’s lap, she pushed hard to develop a template for how to do them, which then was ignored by the Administration (they did HAMP instead, an embarrassment which she refused from the outset to endorse).

The piece serves as an indictment of the banking industry toadies in the officialdom, namely the Treasury, Fed, and OCC. One priceless quote:

They would bring me in after they’d made their decision on what needed to be done, and without giving me any information they would say, ‘You have to do this or the system will go down.’ If I heard that once, I heard it a thousand times. ‘Citi is systemic, you have to do this.’ No analysis, no meaningful discussion.

It’s one thing to decide to intervene based on an assessment of the costs and benefits, quite another to have banks say they have 15 lbs. of Semtex strapped to their waist and will go “boom,” killing them and everyone nearby if you don’t accede to their demands, and have the authorities have no idea whether they are fibbing or not.

Even though it was useful having Bair confirm my dim view of what passes for financial services regulation ex the FDIC, Nocera recognized and flagged a critically important bit of bureaucratic stonewalling that almost certainly kept Citi and probably Bank of America and JP Morgan from doing even more damage to themselves in the runup to the crisis:

In 2004, an international group called the Basel Committee on Banking Supervision proposed rules that would allow banks to hold capital on a “risk-weighted” basis, meaning that assets with lower risk would require less capital. (As it turned out, triple-A-rated mortgage bonds stuffed with bad subprime mortgages were considered very low risk under the Basel proposal. That is why so many banks loaded up on them in the years leading up to the crisis.) To make matters worse, the Basel II accords, as they were called, permitted banks to evaluate their assets with their own internal risk models.

Most European countries quickly adopted Basel II. In the United States, the Federal Reserve was strongly in favor of doing so, too, as was the O.C.C. But the F.D.I.C., fearing that lower capital requirements and the self-selection of risk models would increase the risk of bank failures, opposed Basel II. This meshed perfectly with Bair’s own instincts, and once she arrived at the F.D.I.C., she became the standard-bearer in opposing the new rules. The Fed, in particular, pushed her to sign on; it didn’t need the F.D.I.C.’s approval, but it is politically important for all the regulators to be aligned when instituting such an important change. Instead, Bair conceded, “we dragged it out and dragged it out.” She dragged it out so long, in fact, that the financial crisis arrived before Basel II was ever implemented in the United States.

Foot-dragging is not the sort of bureaucratic tactic that draws praise or even much notice. But I’ve long believed that her opposition to Basel II has been a hugely underappreciated factor in helping to save the financial system when the crisis came. The European banks, lacking adequate capital, were crushed by the financial crisis. Big banks in places like Ireland and Iceland collapsed. Germany doled out hundreds of billions of dollars to shore up its banks. Even today, banks in Europe are in far worse shape than they are in the U.S. American banks didn’t have enough capital, either, but they had a lot more than their European counterparts, and for all their ongoing problems, they are much healthier institutions today.

Nocera is correct to flag both the reliance on the notion of risk-weighting, which proved to be seriously flawed. As former central banker London Banker noted in “More on the Lunacy of the Basel Accords“:

I was looking at the preferred asset classes under the Basel Accords…and realised that every single asset class that is given less than a 100 percent credit risk weighting is now tainted by widespread default, scandals or bailouts.

But (probably because it was not germane to the focus of this piece), he did not single out what was the most destructive aspect of the Basel II standards: that it made Eurobanks eager buyers for subprime CDOs, which in turn were the driver of demand for subprime loans in the toxic phase (third quarter of 2005 to mid 2007, when the market froze). Ex the CDOs, which actually drove demand to the worst sort of mortgages, the subprime market would have died a much earlier death thanks to Fed interest rate increases that started in 2004 (subprime origination fell in 2004 v. 2003 and was projected to decline further in 2005, when it instead got a new lease on life, see ECONNED for a long form description).

And why were CDOs so popular with Eurobanks? They were the prefect vehicle for looting bonus gaming. From ECONNED:

Negative basis trades can be executed when the cost of hedging a bond via credit default swap or another form of insurance is lower than the market yield on the same instrument. For instance, if you can purchase a bond at an interest rate of 400 basis points (4%) and buy a credit default swap of the same maturity referencing the company that issues that bond for 375 basis points (3.75%), the investor has 25 basis points (0.25%) of income….

Let’s look at an example. EuroBank buys a super senior CDO, rated Aaa/AAA. It has a floating rate coupon set at one month Libor (an interbank borrowing rate set daily in London) plus 50 basis points (0.50%). At its peak, EuroBank could fund this purchase by borrowing at Libor minus 20 basis points (–0.20%), so its “spread,” or gross income, is 70 basis points (0.70%), which may not sound like much but is actually very good value for high-quality paper. But at this juncture this calculation doesn’t capture all the costs. Since EuroBank does not have an infinite ability to borrow, it must also hold some much more costly equity against this position too, which makes the trade look less appealing.

Then the fancy footwork starts. EuroBank buys protection on the bond via a credit default swap from an AAA counterparty. It pays 20 basis points (0.20%), so its remaining spread is 50 basis points (0.50%). Acquiring this guarantee has two perverse effects. One is that, because the paper is rated AAA, the Basel II rules, which European bank regulators followed, let banks decide how much capital to hold. Not only did EuroBank decide to hold a small amount before this procedure, but then it further decided that the CDS hedge meant it had no risk and therefore no equity cushion was needed.

But it gets even better. Assume the bond has a seven-year average life. What would the internal profit and loss statement show? It would not simply count the 50 basis points as income this year. It would show a profit equivalent to taking the earnings from years two through seven and discounting them back to the current year…Hedging the AAA position with a guarantee from an AAA (supposedly impeccable) counterparty freed up the capital formerly needed to support it, at least according to these metrics An immediate profit was credited to the desk that put on the guarantee.

Now consider how this looks to traders, who focus strictly on their own bottom lines. This is free money, thousand dollar bills lying on the sidewalk. Many of these transactions are incredibly simple to arrange and require little to no monitoring once booked. The not-trivial danger, that the party that provided the insurance might not be good for it (“counterparty risk,” the possibility that the other side of the deal might fail to perform), is treated as the bank’s problem, not the trader’s. The fact that there is no charge for the cost of equity also means the people on these desks will face far fewer risk management limits than for other types of business. In other words, they can enter into transactions like this in extraordinarily large volumes.

I guarantee Citi would have had to have been nationalized if it had been permitted to play this sort of game. It is certain to have piled in every bit as hard as its European counterparts. And that would have made the subprime bubble even worse.

The article also indirectly serves to illustrate how what used to be conservatism, which is also once upon a time was very much bound up in ideas like strict morality and respect for tradition and authority, has instead become a propaganda cover for plutocratic land grabs. Mark Ames, via e-mail, provides another example of how other conservative lines of thought that ran counter to the interests of large corporations and other powerful interests were pushed aside:

Have you heard of this Depression-era U. Chicago classical-liberal Henry Simons? It’s a very interesting story: Simons was the mentor to both Milton Friedman and George Stigler, as well as Aaron Director; and Simons did more than anyone to set up the “Chicago School” in the early-mid 1940′s. He also collaborated closely with Hayek to create the foundations for Mont Pelerin. Then he committed suicide in 1946.

Simons’ liberalism turns out to be vastly different (and better) than the corrupt corporate neoliberalism we have. He was the real deal. Simons argued for classical Adam Smith liberalism: That meant it was the government’s duty to actively ensure the greatest amount of competition. In the mid-30′s, Simons argued that the big tragedy about the Great Depression is that everyone assumed it was caused by unfettered capitalism and too much competition run amok. Simons argued that the real cause was that the government, in the pockets of the wealthy, didn’t do its job to ensure maximum fair competition, and instead allowed oligopolies and monopolies to strangle competition and exploit. He believed that the government must always break up large corporations; he believed that the entire banking system should be nationalized, as its role is to finance competition, not to speculate; he believed that the government should take complete control over money, and manage the money supply to ensure low inflation and stimulate employment; he believed that the income tax code should be used to redress inequalities; that utilities should be nationalized; that there should be welfare for the neediest.

And he was one of the most rabid anti-New Dealers, anti-Keynsians out there.

What’s interesting is that Friedman, at the first Mont Pelerin conference in 1947, was also against privately-held monopolies, which he argued strangled competition and hurt consumers; Friedman even argued that private monopolies were more destructive than publicly-held monopolies.

He got in trouble for that from the big business backers of the new neoliberal movement, and shut his mouth up about monopolies for a couple of years. Then he came back to Mont Pelerin and proclaimed he’d seen the light: Private monopolies are never bad–in fact, they cannot rationally exist, because they always succumb to the laws of competition, where the consumer is king. The only problem is when the public owns a monopoly on anything–utilities, schools, parks, roads, you name it. It’s always inherently bad and oppresses our liberty.

Bair managed to make herself an irritant and an impediment to members of the Administration who were all too keen to give the banks everything they wanted. Had she been more powerfully positioned, she might have been able to do more good. But impeding bad courses of action, even though it seldom leads to the best headlines, is precisely what a regulator should do.

This post originally appeared at naked capitalism and is reproduced here with permission.