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My Liability Is Your Asset

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A friend of mine pointed me to a recent article by MIT professor Simon Johnson. A former head economist for the IMF, Johnson compares the US’ current predicament to his experience advising developing nations that are in financial trouble (for those of you who aren’t familiar with the IMF, you only really talk to them when the proverbial $#%* has hit the fan). Johnson’s oligarchy analysis has served as a rallying point for much of the blogosphere since the publication of his article. Given the conspiracy theories surrounding Goldman Sachs and the general frustration with Wall Street’s response to the government bailout, Johnson provides a framework for understanding unfolding events. It should be noted, however, that others have drawn similar parallels (as early as Aug 2007) between the features of the current crisis and other crises (e.g., the Asian Financial Crisis, etc.), though without Johnson’s oligarch perspective.

Johnson’s framing of the problem is now enabling other commentators to focus on the power dynamics between Wall Street and Washington, and has fueled the moral outrage surrounding the government’s bank bailout plan (even among those within the financial industry).

While Johnson’s observations ring true with me (I may be biased because I actually worked in Korea during the Asian Financial Crisis, followed by a few years in the development field), it’s still unclear to me where the bailout lies on the spectrum between “the best we can do given difficult circumstances” and “highway robbery.”  Most of what I’ve read assert a WMD-like fear of financial destabilization if the banks aren’t bailed out, usually citing Lehman Brothers, or (on the other hand) equally vague demands that the government force a GM-style restructuring of the banks that ignore the role legislation and social safety nets must play in such a scenario (I’m willing to be educated, though, if I’m just reading the wrong corners of the InterWeb).

Some questions that always seem glossed over by the administration and the press:

  • What are the specific legal hurdles to more aggressive restructuring? 
  • Is the FDIC equipped to handle a restructuring of the largest banks? (UPDATE 4/23: some commentary)
  • How did the administration determine that the bailout, as currently structured, would be cheaper than a more aggressive bank restructuring? 
  • Even if the liabilities of the banks are restructured, through nationalization or some other means, bank liabilities are assets for someone else (e.g., PIMCO). What’s the likely chain of events if these creditors are made equity holders? 
  • Would such a restructuring cause the same destabilizing collateral calls and liquidations everyone fears? And if the administration plans to bailout the banks and then cap bank size through subsequent legislation, how likely is it the administration will succeed?

Perhaps most importantly, how the heck is Joe Six-Pack (I couldn’t resist) supposed to understand this stuff when the government and the press are so bad at communicating these issues in concrete terms? Even Obama, widely recognized as the best communicator in the administration, rests more on assertion than exposition when he attempts to explain why the bailout will cost less using the current approach.

The US Is A Developing Economy, But With More Money

I’ve heard this crisis described as the unintended outcome of complex network effects, that no one could have predicted the perfect storm that brought about the current crisis. The lessons of the Asian Crisis, however, belie that argument. As I remember it, the Korean crisis featured:

  • Excessive leverage (10x was a big deal back then!)
  • Excessive investment in real estate
  • Asset/Liability term mismatches exacerbated by “hot money” and deregulation
  • Poor governance and fraud
  • Complex and opaque financial relationships (between the companies of the chaebol)
  • A crisis in confidence sparked by a revealing scandal (Hanbo Steel)

Even if you don’t know anything about the elements above, they probably sound familiar. Granted, the Asian Crisis unfolded much more quickly because the financial instruments and corporate issues were probably easier to digest. In contrast, problems with Asset Backed Commercial Paper (ABCP) and Levered Super Senior (LSS) notes surfaced late in 2007, but it took the equity markets almost a year to notice what was going on in credit. Most people didn’t even know what ABCP or a conduit was (and probably still don’t) prior to this disruption. The main take-away is ABCP and LSS were perceived to be rock solid assets and both blew up. I talked to some equity hedge funds that wanted to learn more of what was going on, but they seemed to have a hard time digesting the news. A common refrain: “When I talk to you guys, I feel like the world is coming to an end.”

Anyway, as Johnson rightly recognizes, the irony is many of the suggested solutions to America’s woes are fundamentally identical to the policy prescriptions applied to emerging economies.

Nail Your Budget Expenditures To My Door, Uncle Sam

The transparency initiatives the Obama administration is pursuing echo similar (if lower-tech) initiatives in developing nations. Paul Collier, in his book The Bottom Billion, describes a compelling study in Uganda:

“The story begins with…a survey to track public expenditure…only about 20 percent of the money that the Ministry of Finance released for primary schools, other than for teacher salaries, actually reached the schools. …[The Secretary of Finance and Planning] decided to try a completely different approach: scrutiny from the bottom up. Each time the Ministry of Finance released money it informed the local media, and it also sent a poster to each school setting out what it should be getting…three years later he repeated the tracking survey. Now, instead of 20 percent getting through to the schools, 90 percent was getting through.” (p. 150) anyone? Although the US version is Internet-based, the underlying benefits of added transparency are the same whether you are a emerging market or a mature market. This story underscores the the value of transparency better than a technical discussion about market efficiency, lemon markets (a la Akerlof), etc. Imagine if the Defense Department itemized and published all its expenditures in an intelligible way! In any case, it’s easy to see how the complex web of conduits, SPVs, credit derivatives, structured finance vehicles, and counter-party risk could take time to untangle and comprehend.

I Can’t See Past My Own Self-Interest: Heads I Win, Tails You Lose

Have you ever worked in an office where you always felt like you had to watch your back (welcome to Wall Street!)? Maybe you weren’t part of the in-crowd. Johnson’s argument regarding the oligarchy reminds me of arguments made about the psychology of elites. While I am not familiar with his entire body of work, Princeton professor Ezra Suleiman’s discussion of elites in French society parallels Johnson’s financial oligarchs. He discusses the symbiotic relationship that often develops between private and public institutions. As described in Powers of Theory: Capitalism, the State, and Democracy (Alford, Friedland):

“Suleiman is not arguing that the state controls the economy; rather, he says that the common elite structure shared by both public and private sectors serves the interests of both. And he is not arguing that there is no conflict between the various sectors of the elite. On the contrary, they are in continuous conflict over jurisdictions and turf, but they unite to defend the institutional principle of elite domination…They share a common social psychology: ‘the elite is deeply committed to a certain view of the society – centralized, non-participatory, and fundamentally conservative.'”

France is obviously different than the US, but c’mon, the statement above might as well describe the Bush years. Many fear that missteps by the Obama administration may signal a similar level of “elite encumbrance.” I think its a bit early to make that determination, particularly given Obama’s background, but commentators are already questioning the judgment of those working for him (Geithner, Summers, etc.).

Ugh, it’s getting late, PPIP will have to wait…

Written by DK

April 18, 2009 at 10:26 pm