Monthly Archives: February 2009

House of Cards, part 6

Joe Nocera of the NYT has a good story today explaining the situation around the bailout of AIG, entitled, appropriately enough, “Propping up a House of Cards”.  It appears that AIG sold all sorts of ‘financial insurance’ without going to the trouble of keeping any decent reserves in case they had to pay out.  Banks and others bought this insurance, making it appear that they were adequately covering their mortgage risk.  Here’s Nocera:

When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That’s why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn’t have to put anything aside for losses. And it didn’t. Its leverage was more akin to an investment bank than an insurance company. So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it.

Second, in many of its derivative contracts, A.I.G. included a provision that has since come back to haunt it. It agreed to something called “collateral triggers,” meaning that if certain events took place, like a ratings downgrade for either A.I.G. or the securities it was insuring, it would have to put up collateral against those securities. Again, the reasons it agreed to the collateral triggers was pure greed: it could get higher fees by including them. And again, it assumed that the triggers would never actually kick in and the provisions were therefore meaningless. Those collateral triggers have since cost A.I.G. many, many billions of dollars. Or, rather, they’ve cost American taxpayers billions.

Unfortunately it appears that the domino effect of letting AIG fail would be a devastating series of losses around the world.  So we’ll continue to prop up AIG among others.  Limited liability for shareholders, but the liability for taxpayers appears to be unbounded.

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Regulation done right?

This story from Newsweek’s Fareed Zakaria, “The Canadian Solution,” is worth a read.  He notes that Canada has come through the financial crisis in quite good shape.

So what accounts for the genius of the Canadians? Common sense. Over the past 15 years, as the United States and Europe loosened regulations on their financial industries, the Canadians refused to follow suit, seeing the old rules as useful shock absorbers. Canadian banks are typically leveraged at 18 to 1—compared with U.S. banks at 26 to 1 and European banks at a frightening 61 to 1. Partly this reflects Canada’s more risk-averse business culture, but it is also a product of old-fashioned rules on banking.

While we may find the idea of regulation to be a necessary evil, it’s certainly worth studying what policies actually work reasonably well.  I log this under ‘sustainability’ as well, since it appears that the Canadian model banks will outlast ours!

I’m on the road for the next couple weeks, so probably light blog activity!

Please Raise My Taxes?

In today’s NYT, Netflix CEO Reed Hastings asks for a tax hike (‘Please Raise My Taxes’).  He proposes “a top federal marginal tax rate of 50 percent on all income above $1 million per year” as an alternative to the proposal to cap executive salaries.  His rationale: “a shocking $20 million severance package would generate $10 million for the government. That’s a far better solution than what we have today, not least because it works with the market rather than against it.”

And he makes an argument that I have to agree with…  “Some will tell you that would reduce the incentive to earn but I don’t see that as likely. Besides, half of a giant compensation package is still pretty huge, and most of our motivation is the sheer challenge of the job anyway.”

It does seem to me that unless marginal tax rates are extremely high, such as well over 50%  (like back in the 1950’s when it was up to around 90% in the U.S.), companies and individuals still have plenty of incentive to take on new projects if they think they will be profitable.  I don’t think entrepreneurs, particularly of small businesses, take too much consideration of the marginal tax rate when making investment decisions – if it will be profitable assuming a certain interest rate, then it’s a go – otherwise not.  Would high-earning people turn down raises, and stop working hard, because of a 50% rate?

Besides the fact that no one likes paying lots of taxes, what’s wrong with this proposal?

For the Republicans: It appears that raising taxes is at this point permanently anathema to the Republican Party…  but I think the questions are (1) if tax cuts create great economic outcomes, why didn’t the Bush cuts do more to keep us out of this mess? (2) if taxes were to be lowered for businesses, why would that produce any business investment that wouldn’t be happening already today?  The problem appears to be lack of business opportunities, not lack of investment capital.  Unemployment is rising fast because of lack of opportunities.

For the Democrats: Even if you think this is a good idea, it would probably be just a drop in the bucket in terms of actual tax revenues.  Some form of stimulus bill will pass, and presumably that will lessen some of the pain that would have otherwise been experienced over the next couple years.  But at what cost?  Isn’t some structural adjustment necessary?  For the last few years we’ve been living increasingly on high levels of debt (on federal level and personal level).  One way or another it seems like we need to unwind some of the debt – how can we borrow our way out of this situation caused by too much borrowing?

Under the microscope

With the bank bailouts, we’re seeing an interesting phenomenon – the increasing scrutiny of the spending of the banks.  Now that some taxpayer money is directly injected into these companies, any spending they do is seen (rightly or wrongly) as use of public funds.  As an example, this story “Bailed Out Bank of America Sponsors Super Bowl Fun Fest” from ABC News:

Despite a near collapse that required $45 billion in federal taxpayer bailout funds, Bank of America sponsored a five day carnival-like affair just outside the Super Bowl stadium this past week as President Obama decried wasteful spending on Wall St.

The event – known as the NFL Experience – was 850,000 square feet of sports games and interactive entertainment attractions for football fans and was blanketed in Bank of America logos and marketing calls to sign up for football-themed banking products.

The bank staunchly defended its sponsorship, saying it was a “business proposition” and part of its “growth strategy.”

Now normally a private company does not get this type of scrutiny.  People don’t pay too much attention to their marketing budget or the bonuses they pay, etc.  It’s also true that commonly it’s not in either the company’s or their customer’s interest to publicize a dispute or screwup… quiet settlements are more likely.  (Note: I’m not saying that B of A’s marketing decision was good or bad, it’s just that in previous years this would not be news; and so this is new for B of A to have to respond to this type of report).

In the public sector, however, it’s common for screwups and inefficiencies to be exposed, since groups like Citizens Against Government Waste are constantly looking for these things and have little reason to stay silent (not that they catch everything, obviously, but they are looking!).

I suspect that most private companies would find that they could find a lot more efficiency if they were constantly under the microscope in this way.  So I guess the question is whether our shareholders would benefit from more stringent monitoring of how companies operate (whether they’re profitable or not), and if so, how could they achieve it?

Update on Feb 4: Yesterday news came out about a proposed pay cap of $500K for bank execs.  I think the point here is to make sure that taking bailout funds ‘hurts’ – the last thing you want is for every company and industry to line up at the government cash window.  I think it sends the right message.