Appropriately Retentive about Risk Retention

The SEC now has a proposal for how to implement the Dodd-Frank requirement that institutions retain some of the risk of loans when securitizing and selling loans.  The idea of this requirement is to give originators better incentives to originate and sell good loans.  Not sure why the private sector screwed this up – one reasonably hypothesis is that a few large players screwed it up, AIG, Lehman and others — but anyway.  The proposed SEC rules are here for public comment.  To make things interesting, important government officials are now weighing in.  Here is the comptroller of the currency’s response (mostly concerned with fighting exemptions), and here is the press release for Tim Geitner’s (Treasury is supportive of the general rule and accepting of the specifics).  In my opinion, financial institutions need retain no common or systemic risk to be properly incentivized, they just need to hold the risk of the loans they originate relative to similar other loans.  Otherwise, systemic crises damage bank capital.  But I have blogged a fair bit on this before . . .

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AIG update

The saga or AIG and the taxpayer continues, but with some surprising good news for the taxpayer.  The Treasury reports here that AIG may actually be able to pay back the NY Fed and the Treasury for all the money poured into the firm to keep it afloat during the crisis.  This surprises me to no end, given how bleak things looked for the firm in the summer and fall of 2009.

One could make the case that the foolish AIG insurance in the mid-2000’s caused the subprime crisis in that AIG nearly singlehandedly supported the price of the bonds by writing this insurance. It supported the mortgage machine despite some smart investors who were aware of the low expected payout of many of these assets. 

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The Continuing Saga of AIG

The Congressional Oversight Panel released a great report on the AIG bailout, here.  Lots of fun stuff about the timeline of events, explanations of Maiden Lane and TARP involvement, a nice discussions of whether AIG is now solvent or not, etc.  But what I really liked was the debate on whether there were more than two options on those fateful days in September 2010. The principals contend that it was either let AIG fail or instead bail completely, the way they did, making counterparties whole.  But the COP suggests that the Treasury and NY Fed could and should have used their powers of intimidation. Let me quote the report:

“ . . .was it the role of FRBNY to attempt to use all the tools at its disposal to induce entities it regulated to do something they did not want to do in the interests of systemic stability? The Panel believes that FRBNY at that moment did not see such inducement as its role. The Panel believes that in such a crisis, with the stability of the financial system and the integrity of the regulatory system in jeopardy, that FRBNY’s role was to do just that: to ensure that those private parties that benefited from the stability of the financial system would contribute to its preservation.”

 

Seems like dangerous ground to me. With GM, some counterparties refused to negotiated writedowns, and the government let GM go into bankruptcy and there, with the help of a judge, writedowns were imposed with the usual rules.  In the case of AIG, the government was prepared to pay the full cost of not letting AIG go under, so any attempt to get writedowns/concessions from counterparties would be bluffs and potentially only enforced by strong-arm tactics. What if I, a private bank, was willing to risk my direct losses from an AIG bankruptcy and believed the contribution of such a bankruptcy to systemic risk/crisis was small.  Would it be appropriate for FRBNY to lean on me as my regulator to force me to take less from a private contract?  Very interesting debate.

Again from the report:

“The record appears to be clear that in the absence of outside funding AIG would have been insolvent by the end of the day on September 16, 2008. In the end, FRBNY provided immediate funding that night. Ultimately, it is impossible to stand in the shoes of those who had to make decisionsduring those hours, to weigh the risks of accelerated systemic collapse against the profound need for the financial firms that FRBNY was rescuing along with AIG to share in the costs and the risks of that rescue, and to weigh those considerations not today in an atmosphere of relative calm, but in the middle of the night in the midst of a financial collapse.”

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Who and what are the bailouts subsidizing?

TARP and the Federal Reserve’s actions during the finance crisis and recession have been extensive.  Keeping track of all the policies that have been implemented has been mind boggling.  But now there is a Pew Foundation project and webpage devoted to keeping track of what businesses or investors have gotten subsidies and how big they were/are, often in terms of current or recent subsidy rates.

TARP Capital Purchase Program (CPP) recipient institutions by county (Source: Pew Charitable Trusts - SubsidyScope.com; click on the map to go to their site)

The subsidy rate (or cash subsidy) is based on the difference between what the government pays (and/or the market value of what it commits to pay) and the market value of what it receives in return. For example, if TARP gives money and lines of credit to AIG in exchange for an 80% ownership stake in AIG, the subsidy rate is based on the cost of the program – the money given and the market price the government would have had to pay to buy that conditional line of credit from the market – and the market value of 80% of AIG at its post-bailout value (a subsidy rate of 1 is pure gift, a negative subsidy would make money for the government). Having been involved in valuation of TARP holdings, I know first-hand how difficult it is to evaluate the direct subsidy involved in a bailout many months later.  The current AIG subsidy rate is around 60%. But what is really important for evaluating whether the cost of different programs were worth their costs are the initial subsidy rates of the programs at the time they were undertaken.

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The NY Federal Reserve Bank and AIG

Trying to keep up with the issues surrounding the Federal Reserve’s bailout of AIG? Here is some useful and fact-full information:

1. The SIGTARP investigated the bailout (not the coverup) in the fall and issued this report. The summary page on lessons learned:
   

   FRBNY’s negotiating strategy to pursue concessions from counterparties offered little opportunity for success, even in the light of the willingness of one counterparty to agree to concessions

   and

   assistance to AIG . . . transferred tens of billions of dollars of cash from the Government to AIG’s counterparties even though senior policy makers contend that assistance to AIG’s counterparties was not a relevant consideration in fashioning the assistance to AIG. . .

2. The FT has a nice article on the hindered haircut and a previous bailout with haircuts.
3. The actual numbers—who got their contracts fully paid off.

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More on the costs of the Wall Street bailout

The Economist recently published another article about the declining estimates of the costs of the Troubled Asset Relief Program (TARP). The article, here, notes that TARP may end up making the taxpayers money. The article quotes (my former colleague at Treasury) Lewis Alexander saying

If you follow Bagehot’s rule—ie, ‘lend freely against good collateral at a penalty rate’—you will make money.

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Goldman’s exposure to AIG – we will learn how much and to whom?

One of the big stories of the bailout of AIG was that it indirectly bailed out institutions with direct exposure to AIG, such as those having sold insurance on the quality of AIG’s debt (through the use of credit default swaps). One large beneficiary of this bailout was Goldman Sachs, which had written billions of dollars of such insurance (oops!) and happened to be the ex employer of then Treasury secretary Paulson (during the crisis Paulson asked for and got fed information from Goldman after getting his ethics requirement that he not deal with or communicate with Goldman waived).  While this all looks pretty suspect, Goldman has repeatedly claimed that they had this exposure hedged, so maybe there was no incentive to distort the information they gave Paulson. But as far as I know, Goldman has never said who they had this agreement with, allowing us to see whether their own counterparty would have been able to make good if AIG did not get bailed out. That is, my own suspicion, given that Goldman has never stated the name of their counterparty, is that anyone writing this insurance for Goldman was probably writing it for others and was probably not going to be able to pay if AIG went under. Also, it is now clear that Goldman objected to having any AIG debt written down as the government tried to find an alternative to a full bailout. Anyway, this story has been good gossip so far, but without many facts, only conspiracy theories. Now, some answers may be on the way. Treasury Secretary Geithner, who headed the NY Fed at the time, has accepted an invitation to testify before Congress on

Wednesday, January 27, 2010, at 10:00 a.m. in Room 2154 of the Rayburn House Office Building . . .[to] examine the collapse and federal rescue of AIG, in particular the compensation of AIG credit default swap counterparties . . . [and]. the role of the New York Federal Reserve Bank and other Federal agencies in AIG’s failure to disclose to the public the counterparty payments.

Should be interesting.

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The End of the Beginning

“Now, this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”—Winston Churchill, November 10, 1942

When Churchill made his famous statement following the allied victory at El Alamein in North Africa, he was warning the public not to be too optimistic, and to expect the war to continue for a long time. It now seems clear that the financial crisis will last a long time. I want to suggest here that we are at the “end of the beginning” of the financial crisis, about to enter a new phase. Unfortunately, this is not an optimistic statement, merely an assessment. The government is fast running out of policy options that bear any resemblance to “free market” policies. What remains is for the federal government to run everything. And this is what is gradually occurring. The challenge will then be for the government to undo all of its intervention as quickly as possible.

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