Berkshire Hathaway Chairman and CEO Warren Buffett sat down with FOX Business Network’s Liz Claman to discuss all the fun things going on with the US economy and regulators. Although Warren’s tough stance on bank CEOs is admirable, I definitely do not agree with his review of Bernanke and Geithner.

Below are excerpts from the interview at FOX Business Network:

On the President’s new bank proposal:

“You’ll always have banks that are too big to fail. We can’t operate in this world without very big banks…If they are toppling the government will have to do something about it.”

“If I were running things if a bank had to go to the government for help, the CEO and his wife would forfeit all their net worth…I think you have to change the incentives. The incentives a few years ago were try and report higher quarterly earnings. It’s nice to have carrots, but you need sticks. The idea that some guy who’s worth $500 million leaves and only has $50 million left is not much of a stick as far as I’m concerned.”

“The CEO has to be the chief risk officer for a bank.”

On General Re settling in the AIG case:

“We did something wrong and we paid the price…It shouldn’t have been done, and there’s nothing inappropriate about the fine we paid, so I have no problem with it.”

On members of Congress who feel Ben Bernanke should not be reconfirmed:

“They ought to get down on their knees every night and thank the Lord that Bernanke was there through this. He took some unprecedented actions…He took the actions that were necessary to prevent panic from paralyzing this country.”

On whether he’s tempted to sell his Goldman before 5 years:

“I’m not tempted at all. That thought doesn’t cross my mind.”

On what his thoughts were at the height of the housing crisis:

“I wish I’d been thinking a little harder. It looked a little crazy to me, but I should have done more about it than I did.”

“I would have been much more attune..if I would have really paid attention I would have been looking at some of those instruments and maybe shorting the companies that were big in the mortgage business or something of the sort. I wouldn’t be shorting but I would have looked for ways to protect myself from the bubble that was going to pop.”

On Secretary Geithner:

“I think he’s terrific.”

On the performance of Berkshire’s split shares:

“There’s been a little bit more action than is ideal today.”

“In the end, we hope we have shareholders who are in sync with us…We don’t want any day traders.”

On the future of Berkshire Hathaway’s business acquisition:

“We’ll keep buying businesses, as long as I’m alive we’ll keep buying businesses…we’ll try to buy them for cash, sometimes we may have to use some stock, but we’ll use as little stock as possible.”

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Click for Full Image

Yesterday, Bloomberg continued to shine a light on the back room dealings during the height of the financial crisis. Congressman Darrell Issa obtained emails showing former head of the Federal Reserve Bank of NY Tim Geithner telling AIG to withhold details about paying counter-parties a bewildering “100 cents on the dollar for credit-default swaps they bought from the firm.”

Why did Geithner tell AIG to remove this material information from their regulatory filings? Because the Federal Reserve “decided that Goldman Sachs and more than a dozen banks would be fully repaid for $62.1 billion of the swaps” on which they gambled. This is per se unconscionable behavior in a capitalist system. Goldman and the other banks knew very well that AIG did not have the collateral to pay the claims in the event of a default scenario. If AIG were legally obligated to have the collateral, the swaps would have been called “insurance”. Therefore, Goldman et al assumed a risk, and they failed. However, Geithner abated the other cronies to give his gambling buddies a full payment courtesy of our hard earned tax dollars.

In this case, Tim Geithner wasn’t acting to save the system (as he claims) because a 100 cents on the dollar repayment was not required. In what alternative dimension do gamblers get paid 100 cents on the dollar for bets gone awry? In the dimension regulated by Tim Geithner and the other cronies at the Federal Reserve and US Treasury.

“Federal Reserve officials provided AIG’s counterparties with tens of billions of dollars they likely would have not otherwise received,” Barofsky wrote in a Nov. 17 report. “The default position, whenever government funds are deployed in a crisis to support markets or institutions, should be that the public is entitled to know what is being done with government funds.”

For capitalism to work, rewards must flow to those who bet correctly, and punishments must flow to those who are wrong. We do not need cronies shuttling taxpayer monies to their former firms and colleagues. We do not need US Treasury Department officials lying to us (See The Treasury Department Endorses Lying to the Public). At this point, it’s time for the Justice Department to investigate whether we are witnessing one of the greatest insider heists in the history of the world.

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Did the US Government Subsidize Holiday Purchases?

Larry Summers’s Business Interests Revealed

Amidst all recent clamors for using TARP paybacks to reduce the deficit, there seems to be little discussion about how TARP appropriations figured in deficit estimates. To add to the overall confusion, TARP transactions can be accounted for in two ways, according to Harvard Professor Greg Mankiw:

The U.S. Treasury adopted the conventional view that these TARP expenditures should be counted like any other spending. When the banks repaid the Treasury, these funds would be counted as revenue. Accounted for in this way, TARP caused a surge in the budget deficit when the funds were distributed to the banks, but it would lead to a smaller deficit, and perhaps a surplus, in the future when repayments were received from the banks.

The Congressional Budget Office, however, took a different view. Because most of the TARP expenditures were expected to be repaid, the CBO thought it was wrong to record this spending like any other. Instead, CBO believed “the equity investments for TARP should be recorded on a net present value basis adjusted for market risk, rather than on a cash basis as recorded thus far by the Treasury.” That is, for the purposes of this program, CBO adopted a form of capital budgeting. But it took into account that these investments might not pay off. In their estimation, every dollar spent on the TARP program cost the taxpayer only about 25 cents. If the actual cost turned out to be larger than the estimated 25 cents, the CBO would record those additional costs later, and if the actual cost turned out to be less than projected, the CBO would later book a gain for the government.

The bottom line: Because of these differences in accounting, while the TARP funds were being distributed, the budget deficit as estimated by CBO was much smaller than the budget deficit as recorded by the U.S. Treasury.

So, in this context, when Treasury Secretary Tim Geithner says he doesn’t expect to use more than $550 billion of the appropriated funds and expects up to $175 billion in repayments by year end 2010 (and “ substantial additional repayments thereafter”), what does that really mean in terms of deficit reduction and costs to the taxpayer?

(Keep in mind that when the money comes back it goes back to the US Treasury and that repaying TARP is not the same as paying down the deficit.)

Using the CBO accounting method, here is what we know:

- The $700 billion TARP appropriation is expected to add $175 billion to the deficit.

- According to the CBO estimate, the US Treasury should receive $525 billion (75% of the $700 billion appropriation) in paybacks plus earnings

- $175 billion in repayments are expected in 2010

- $150 billion of TARP funds is expected to remain undeployed

- The administration has already identified $42 billion from the $364 billion in TARP funds disbursed in the fiscal year ended September 30 as unrecoverable, as well as $50 billion in TARP funds allocated to mortgage modifications, setting a minimum of $23 billion in deficit spending.

Assuming the $325 billion from expected paybacks and unused funds does not get funneled into new initiatives, a $325 billion reduction in TARP would translate into an approximate $81 billion deficit reduction by 2010. Any TARP transactions that recover money for the remaining $282 billion could be used to further reduce the deficit, up to a maximum of about $71 billion. Theoretically, then, up to $152 billion could be used to reduce the deficit.

The Administration estimates that the overall program will cost $141 billion at most, to the tune of about $35 billion dollars in deficit spending.

A potential deficit reduction figure of $140 to $152 billion is, in my view, certainly worth discussing.

In the Academy Award Winning movie Traffic, the US “drug czar” explains the rules of the game to his successor:

            GENERAL LANDRY
 	When Kruschev was forced out, he
 	sat down and wrote two letters and
 	handed them to his successor.  He
 	said "When you get into a situation
 	you can't get out of, open the
 	first letter and you'll be saved.
 	And when you get into another
 	situation you can't get out of,
 	open the second."  Soon enough this
 	guy found himself in a tight place.
 	So he opened the first letter.  It
 	said, "Blame everything on me."  So
 	he blamed the old guy and it worked
 	like a charm.

 	He got into another situation he
 	couldn't get out of, so he opened
 	the second letter, which read, "Sit
 	down and write two letters."

In order for the political Three-card Monte to continue, Tim Geithner needs to start writing two letters.

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Heavyweights Debate “Too Big To Fail”

The Streetwise Professor Breaks Down SIGTARP and Tim Geithner

Has “Too Big to Fail” become “a policy enshrining crony capitalism” in the oft-quoted phrase, or does the argument against breaking up TBTF banks have merit? Do regulatory approaches to prevent systemic risk merely serve to institutionalize the TBTF concept? Let’s see who stands where in this collection of economic heavyweights.

THE BREAK ‘EM UP TEAM

Alan Greenspan, Former Federal Reserve chairman

When voices were clamoring to split up large banks last month, Alan Greenspan kicked the can down the road, so to speak, when he voiced concern over the implicit subsidy large banks get when taxpayers guarantee risky investment activities.  In an address to the Council of Foreign Relations, Greenspan said (as quoted in Bloomberg):

“If they’re too big to fail, they’re too big,” Greenspan said. “In 1911 we broke up Standard Oil — so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do…

“If you don’t neutralize [the TBTF issue], you’re going to get a moribund group of obsolescent institutions which will be a big drain on the savings of the society,” he said.

“Failure is an integral part, a necessary part of a market system,” he said. “If you start focusing on those who should be shrinking, it undermines growing standards of living and can even bring them down.”

In the same speech, Greenspan also took issue with reforms consisting largely more/better regulation and higher capitalization requirement requirements, such as those floated by Barney Frank and the administration:

“I don’t think merely raising the fees or capital on large institutions or taxing them is enough,” Greenspan said. “I think they’ll absorb that, they’ll work with that, and it’s totally inefficient and they’ll still be using the savings.”

Similar sentiments were expressed by Mervyn King, head of the Bank of England, who states,

“The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.”

And from Simon Johnson, Professor of Economics at MIT professor and former IMF chief economist in an NPR interview:

“The basic problem is that the financial sector can hire the best, most talented people. It can pay them extraordinary amounts of money… They will always get ahead of the regulators.”

Johnson compares TBTF banks to an American oligarchy.  He recommends capping bank size at $100 billion in assets and scaling up the FDIC to have the political power to intervene in banking activities a government-supervised process.

“We need to break them up for exactly the same reason that Rockefeller and the oil interests, standard oil, at the end of the 19th century, was too powerful, economically and politically. And it had to be broken up. And breaking it up was the right thing to do. That’s where we are with the banks today.”

Regarding the economies-of-scale argument for keeping banks big , Johnson says any benefits from large banks has to measured against the potential (read: huge) costs of failure:

“Particularly if you’re working across so many markets, you really want people with excellent local knowledge. So you can work with a network of financial institutions and you can hedge any kind of position you have through multiple contracts with smaller players. In fact, it’s probably not wise in this day and age to rely on one provider of financial services. You’re less likely to get a good price that way.”

More from Johnson in this Bill Moyers interview:

“Now, those bonuses are not the essence of the problem, but they are a symptom of an arrogance, and a feeling of invincibility, that tells you a lot about the culture of those organizations, and the attitudes of the people who lead them… [it’s] Go about your daily lives. Get the bonuses. Re-brand them as awards. But it really shows you the arrogance, and I think these people think that they’ve won. They think it’s over. They think it’s won. They think that we’re going to pay out ten or 20 percent of GDP to basically make them whole. It’s astonishing… Either you break the power or we’re stuck for a long time with this arrangement.

“Think of it like this, our taxpayer money is ensuring their bonuses… And we will be paying higher taxes, we and our children, will be paying higher taxes so those people could have those bonuses. That’s not fair. It’s not acceptable. It’s not even good economics…

“My intuition, from crises, from situations that have improved, the situations that got worse, my intuition is that this is going to get a lot worse. It’s going to cost us a lot more money. And we are going down a long, dark, blind alley.”

(Read more from Johnson’s blog here)

Paul Volcker, Former Fed Chair

Not so long ago, former Fed chair Paul Volcker advocated a return to the days of Glass-Steagall, which separated the banks investment and trading activities from traditional banking.  Volcker said that under the Obama plan, financial institutions designated as TBTF banks “will be sheltered by access to a federal safety net” and the risk will remain, leading to future bailouts (at the same time confirming that “as a given” the government will continue to bail out  banks in crisis).

Volcker clearly disagrees with extending any government assurances outside the banking system, to insurance companies and automakers:

“…the “safety net” should be limited clearly to commercial banks, while investment banks should be excluded.”

And although advocating splitting up the banks (but not arbitrarily), Greenspan does not see Glass-Steagall as the solution to TBTF, stating that: “No form of economic organization can fully contain bouts of destructive speculative euphoria.”

Readers note: Does that mean we should just fold up our tents and go home? Is it just me, or does that sound like guilt speaking?

(Color commentary from TPM: Had Greenspan not supported in 1999 Congress’s repeal of the Glass Steagall Act, which separated investment from commercial banking, we wouldn’t be in the soup we’re in to begin with. Summers and Geithner, along with Bob Rubin, while at Treasury in 1999, joined Greenspan in urging Congress to repeal Glass-Steagall. The four of them — Greenspan, Summers, Rubin and Geithner also refused to regulate derivatives, and pushed Congress to stop the Commodity Futures Trading Corporation from doing so.  For more color commentary re: Volcker and Glass-Steagall from Charlie Gasparino, go here .)

And William K Black, Economics Professor and Senior Regulator during the S&L crisis, puts it this way:

The Treasury has fundamentally mischaracterized the nature of institutions it deems “too big to fail.” These institutions are not massive because greater size brings efficiency. They are massive because size brings market and political power. Their size makes them inefficient and dangerous.

Under the current regulatory system banks that are too big to fail pose a clear and present danger to the economy. They are not national assets. A bank that is too big to fail is too big to operate safely and too big to regulate. It poses a systemic risk. These banks are not “systemically important”, they are “systemically dangerous.” They are ticking time bombs – except that many of them have already exploded.

Professor Black contends that both the Bush Administration and the Obama Administration violated the Prompt Corrective Action law (see the Bill Moyers interview and rebuttal here.)

THE LET ‘EM GROW, LET’EM FAIL (BUT WITH APPROPRIATE CONTROLS SO THE ECONOMY DOESN’T COLLAPSE) TEAM

Ben Bernanke, current Fed Chairman

Current Federal Reserve chairman Ben Bernanke disagrees that TBTF banks should be split up or capped:

“We can address these issues in a way that doesn’t destroy the economic value of large, complex multifunction firms through other mechanisms,” Bernanke said.

For example, Bernanke cites that the Federal Reserve Bank of New York “has been leading a major joint initiative by the public and private sectors to improve arrangements for clearing and settling credit default swaps and other over-the-counter derivatives.”

But Bernanke did say that failing financial firms should be allowed to fail, provided the dissolution is orderly:

“We won’t have a real market-based financial system until it is safe to let a financial firm fail,” Bernanke said.

From a speech earlier this year, Bernanke spoke in favor of establishing a strong regulatory authority to address systemic risks. If an organization becomes “too big to fail,” Bernanke says, it encourages excessive risk-taking by the firm and “provides an artificial incentive for firms to grow, in order to be perceived as too big to fail.”

Bernanke goes a step further by stating that the Fed should have the supervisory authority for systemically important firms (like TBTF banks) but not systemic risk in general.

“We should leave open the possibility that if a supervisor decides that a particular firm does not have the managerial risk-management capacity to deal with a particular type of business — putting aside any capital requirements — there should be the ability to say you can’t do this activity,” Bernanke said.

Readers note: The Shadow Banking System lives on!

Sheila Bair, FDIC Chair

Although Sheila Bair, chairwoman of the F.D.I.C, recommends shrinking the “shadow banking system,” she does not advocate shrinking or breaking up the banks. Instead, she recommends extending regulatory controls to bank holding companies and other non-banking firms, such as insurers and hedge funds, as reported in the NYT:

“We need to end ‘too big to fail’ and this needs to be an overarching policy that applies to everyone,” Ms. Bair said, speaking to a meeting of the Institute of International Finance.

Financial firms subject to systemic-risk shutdown authority should likely also be required to publish “living wills” — details on how an orderly wind-down would play out — on their Web sites to provide clarity to shareholders and customers.

And by applying the resolution authority more broadly outside of normal regulated bank holding companies, it would help shrink the shadow banking system by discouraging regulatory arbitrage, under which financial firms shop for the most lenient supervisors.

“If you tighten regulation of the banks even more without dealing with the shadow sector you could make the problem even worse,” she said.

Tim Geithner, Treasury Secretary

Geithner would exempt retailers and other nonbank companies from oversight. He says:

“Regulators must be empowered with explicit authority to force major financial firms to reduce their size or restrict the scope of their activities when necessary to limit risk to the system. This is an important tool to deal with the risks posed by the largest, most interconnected financial firms.

“Regulators must be able to impose tougher requirements – most crucially, stronger capital rules and more stringent liquidity standards – which would reduce the probability that major financial firms experience financial distress, either through capital depletion or a run by creditors. This would provide strong incentive for these firms to shrink, simplify, and reduce their leverage.

“In addition, major firms must be subject to a prompt corrective action (PCA) regime and be required to prepare and regularly update what some have called “living wills,” which are plans for their rapid resolution in the event of distress. These plans would leave us better prepared to deal with a firm’s failure, and provide another incentive for firms to simplify their organizational structures and improve their risk management…

“Monitoring threats to financial stability will fall to the proposed Financial Services Oversight Council. The Council would have the duty and authority to identify any financial firms whose size, leverage, complexity, and interconnectedness pose a systemic threat and require those firms to submit to a system of heightened supervision and regulation.

The Federal Reserve would oversee individual major financial firms so that there is clear, inescapable, single-point accountability.  The Fed already supervises all major U.S. commercial banking organizations on a firm-wide basis and all major investment banks as well.”

In testifying before the Joint Economic Committee of Congress last April, Nobel laureate Joseph Stiglitz offered a different view (quoted here):

“Before a crisis, every financial institution will claim that it does not pose systemic risk; in a crisis, almost all (and those that would be affected by a collapse) will make such claims.”

Paul Krugman, professor of Economics and International Affairs at Princeton University, says that TBTF is here to stay:

“I’m a big advocate of much strengthened financial regulation. One argument I don’t buy, however, is that we should try to shrink financial institutions down to the point where nobody is too big to fail. Basically, it’s just not possible.

“The point is that finance is deeply interconnected, so that even a moderately large player can take down the system if it implodes. Remember, it was Lehman — not Citi or B of A — that brought the world to the brink.

“So I think of the pursuit of a world in which everyone is small enough to fail as the pursuit of a golden age that never was. Regulate and supervise, then rescue if necessary; there’s no way to make this automatic.”

Many bankers look to JPMorgan Chase Chief Jamie Dimon, who says:

“As we have seen clearly over the last several years, financial institutions, including those not considered “too big,” can pose serious risks for our markets because of their interconnectivity. A cap on the size of an institution will not prevent that risk. Properly structured resolution authority, however, can help halt the spread of one company’s failure to another and to the broader economy. While the strategy of artificial limits may sound simple, it would undermine the goals of economic stability, job creation and consumer service that lawmakers are trying to promote.

“To understand the harm of artificially capping the size of financial institutions, consider that some of America’s largest companies, which employ millions of Americans, operate around the world. These global enterprises need financial-services partners in China, India, Brazil, South Africa and Russia: partners that can efficiently execute diverse and large-scale transactions; that offer the full range of products and services from loan underwriting and risk management to providing local lines of credit; that can process terabytes of financial data; that can provide financing in the billions.

Readers note: But isn’t that exactly the argument why large banks CANNOT be allowed to fail, specifically because of their size and interconnectedness (systemic risk)? Isn’t this a type of circular reasoning? He seems to be saying let us continue to take the same risks as before (leave in the systemic risk) but be comforted that we can now fail (because, as we have already seen, we cannot be allowed to fail because we are so interconnected, wink! wink!)

But in a speech back in June, Alan Greenspan dismissed the economies of scale arguments this way:

The perceived systemic impact of the failure of large financial institutions is the genesis of the “too big to fail” (TBTF) or “too big to liquidate quickly” problem. For years I have been concerned about the ever larger size of our financial institutions. A decade ago, I noted that “megabanks being formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail.” Federal Reserve research had been unable to find economies of scale in banking beyond a modest-sized institution. I often wondered: had bankers discovered economies of scale that Fed research had missed? It is clear, in retrospect, that they had not.)

(Color commentary from the NYT: Several United States policy makers consider JPMorgan Chase’s chief executive, Jamie Dimon, as a potential successor to Treasury Secretary Timothy F. Geithner, The New York Post reported, citing sources. Mr. Dimon “would love to serve his country,” the newspaper quoted people familiar with his thinking as saying. )

And then, just yesterday from Morgan Stanley, this;

“In short, we think the demand for growth and access to credit will trump desire for unprofitable capital levels…

“Contrary to perceptions about [Sheila] Bair’s statements, we do not think there is any willingness to remove implicit support [for big banks].  In particular, we expect the discount window is unquestioned for banks, and TLGP [Temporary Liquidity Guarantee Program] type programs could exist in future crises.  Regulators recognize the need for banks to make returns high enough to attract capital..;

“Even with appropriate leverage, the taxpayer has occasionally paid for the benefit of growth when financial shocks occurred.  Repayment comes with subsequent growth.”

Readers note: Serfdom lives on!!

THE HINCHEY AMENDMENT AND SANDERS BILL

Just last week, Congressman Maurice Hinchey (D-NY) introduced the Too Big to Fail, Too Big to Exist Act,  the House version of U.S. Senator Bernie Sanders’ bill S. 2746. His rationale (from Hinchey’s web site):

“Instead of trying to prevent future collapses of enormous banks or scrambling to come up with trillions of dollars in taxpayer money to bail them out, let’s avoid such a major risk by dismantling those massive firms now.  Put simply, if a financial firm is considered too big to fail, then it is too big to exist and should be unwound quickly.  As bad as this economic collapse has been, if we allow these goliaths to continue to exist then the entire economy could come crumbling to its knees.

Today, just four huge financial institutions (Bank of America, Citigroup, JP Morgan Chase, and Wells Fargo) hold half the mortgages in America, issue nearly two-thirds of credit cards, and control about 40 percent of all bank deposits in the U.S.  In addition, the face value of over the counter derivatives at commercial banks has grown to $290 trillion, 95 percent of which are held at just five financial institutions in the entire country (Bank of America, Citigroup, Goldman Sachs, JP Morgan Chase, and Morgan Stanley).

“If an institution is too big to fail, it is too big to exist,” said Sanders, a member of the Senate Budget Committee. “No single financial institution should be so large that its failure would cause catastrophic risk to millions of American jobs or to our nation’s economic wellbeing. No single financial institution should have holdings so extensive that its failure could send the world economy into crisis.  We need to break up these institutions because they have done just tremendous damage to our economy.”

And here is another interesting development in financial markets (from The Nation):

According to the Financial Times, Goldman Sachs plans to market a new financial instrument that will allow banks to reduce the capital required to hold risky assets on their balance sheets. Goldman calls this product “insurance” and expects to sell it to the banks with toxic portfolios, enabling them to shift the risk off their balance sheets.

Readers note: Can you say CDS?

This headline from yesterday’s LA Times seems to capture the mood du jour:

Proposal to allow breakup of huge banks gains momentum

Many are hoping the President takes a more aggressive stance than current reform proposals which leave in risk and taxpayers on the hook.

For more interesting reading and commentary, see these articles:

Czar Crossed: Stop blaming the pay czar, break the banks

Banking Group Warns Congress on Breakup Power

The Money Man’s Best Friend

Diana Farrell and the White House Theory of Bank Size

The Myth of Too Big to Fail

Debunking the “Too Big to Fail” Myth

Paul Volcker, Mervyn King, Glass Steagall, and the Real TBTF Problem

Citigroup is Well Run: Why the Treasury’s Plan Will Fail

US Rep Bernard Sanders and TBTF

Why Jamie Dimon Wants to Silence Paul Volcker

Breaking Up the Big Banks, and Why Congress Won’t Do It

The Forgotten Fed Chairman, Why Is Paul Volcker Being Silenced?

Could Wall Street Actually Lose in Congress?

Morgan Stanley Speaks: Against Relying On Capital RequirementsStocksFinancialBACCWFCJPMXLF

This is a guest post by Craig Pirrong at The Streetwise Professor.

Krugman is bashing Timmy! Geithner for his role in the AIG bailout.  This poses something of a dilemma for yours truly.  My sentiments parallel those of Henry Kissinger during the Iran-Iraq War: too bad they both can’t lose.

All snark aside, the SIGTARP report that has put Timmy! (oh, that was snarky–sorry) on the hotseat raises some questions that have been totally ignored over the debate over whether the Fed should have sent Goldman et al to the barber shop to get a haircut on the valuations of their swaps with AIG.

The indisputable fact is that billions of cash went out the door to Goldman et al as a result of the Fed’s actions.  The Fed took ownership of the CDOs underlying the swaps that AIG had entered with the banks, and effectively paid the banks 100 cents on the dollar.  That is, they ensured that the CDO hedges were perfect (belying the old trader adage that the only perfect hedge is in a Japanese garden).

The question is, therefore, what were the alternatives?  The alternative that has garnered all the attention is that the Fed should have paid less than 100 cents on the dollar.

But that’s not the only alternative.  Hank Greenburg has suggested that the Fed should have simply guaranteed the swaps, thereby vitiating the need to provide any collateral payments.  (I made a similar suggestion in an earlier post on AIG).

The SIGTARP report states clearly (p. 14) that this alternative was considered, but dismissed.  The ostensible reasons for the rejection seem very dubious, indeed.

First, “FRBNY told SIGTARP that a perceived downside of this structure from FRBNY’s perspective was that it could involve FRBNY in long-term credit relationships with supervised institutions.”  Please.  The Fed has gone hog wild in extending credit (through repos, for instance) with supervised institutions.  It has taken all kinds of dodgy collateral at all kinds of dodgy valuations.  That certainly involves taking a long term credit exposure.  (Spare me any protests that there is no credit risk here because these repos are collateralized.  Given the quality of the collateral, and the counterparties, there is an appreciable probability that the Fed will suffer a credit loss on these deals.) And if the Fed’s actions were a response to an existential event, which is the gravamen of its defense of its actions, such prissiness over protocol appears decidedly inappropriate–making this explanation exceedingly implausible.

Further thought (added at around 1900 CT):  Given that the CDS were so far underwater to AIG, if the government had guaranteed them, the likelihood that the Fed would have become a creditor to the banks on the other sides of the deals was exceedingly remote.  That is, it was highly unlikely that the Fed would have been exposed to default losses on these deals, meaning that the “credit relationship” was a fiction.  (Besides, at the time, were most of the counterparties even under Fed supervision?   Most were foreign banks, and even the US counterparties, with the exception of Wachovia, were investment banks that I do not believe were under direct Fed supervision, except perhaps as Treasury primary dealers, rather than as banks.)

Second, “there was a lack of statutory authority of the Federal Reserve to provide such a guarantee.”  Please, again.  There are a variety of structures that effectively create guarantees.  For instance, if the Fed could see its way clear to setting up and capitalizing a special purpose vehicle (SPV) to buy the CDOs, it could have set up and capitalized an SPV, and then novated the deals to the SPV.  If it was concerns about counterparty risk that made the banks so insistent on receiving collateral payments, this structure would have allayed their concerns–and required no cash to go out the door.

In this structure, the government’s risk exposure would have been the same as under Maiden Lane and its purchase of the underlying CDOs: it would have been long the CDOs.

In sum, the rationales given for not providing some sort of guarantee are completely unpersuasive.  Completely.  A guarantee would also not have required agreement on valuation with the counterparties.  They would have been assured of receiving their contractual payments, and that should have been that.

The transparently implausible rationale for eschewing the guarantee alternative tells me that the Fed’s–and Geithner’s–injured and adamant denial that “the financial condition in the counterparties was not a relevant factor” (p. 15) in deciding to pay 100 cents on the dollar is dishonest.  Geithner has said many other things that do not pass the honesty smell test, so it wouldn’t surprise me that if this was the case here as well.

Thus, it is highly likely in my view that this was a backdoor way of providing liquidity to systemically important institutions at a time that their financial condition was in serious question.

In this regard, it could well be that Goldman was the firm that was in greatest need of an injection of cash.  The SIGTARP report states that, unlike the other AIG counterparties, “Goldman Sachs did not hold the underlying CDOs but rather had sold equivalent credit protection to its clients who held those positions.”  Very interesting.  It is likely that these client counterparties were demanding collateral from Goldman.  If so, if Goldman didn’t receive cash from AIG–or the government–it would have needed to find additional cash to make these payments.

Yes, Goldman states that it was hedged by its purchase of credit protection on AIG.  But, (a) in prevailing conditions, there was considerable credit risk in those CDS, meaning that Goldman may not have been paid out 100 percent of what it was owed, and (b) even if the CDS paid out, there would almost certainly have been a cash flow date mismatch, with Goldman needing the cash to make margin calls to its clients immediately, and receiving any cash payments on CDS at some later date.  Given the state of the credit markets at the time, funding this gap would have been an expensive, and dicey, proposition.

Given the supposed First Commandment to Treat All Banks Equal (p. 29), the Fed could not have bought out Goldman and not the other banks.

Against that, if providing liquidity to Goldman alone was the objective, there should have been ways of doing that directly–unless the Fed was concerned that special treatment of Goldman would have commenced a destablizing run on it like the one that cratered Lehman.

I therefore can’t conclude for certain that the AIG bailout was really a Goldman rescue in drag.  One can tell that story, but there are alternative explanations.  However, given that the Fed’s explanation for not taking actions that would have required no cash payments is so weak, my conclusions are that the AIG bailout was an indirect of providing liquidity to systemically important institutions, and that one cannot exclude the possibility that this was an indirect way of providing liquidity to one institution in particular–Goldman.

(One question unanswered by the SIGTARP report: if Goldman didn’t own the CDOs that eventually wound up in Maiden Lane, how did they get there?  Did Goldman buy them from its clients in a mirror image deal that involved swap tearups, and then sell them to Maiden Lane?  It would seem that would be necessary to deal with Goldman’s own sales of protection. )

A couple of other points related to the SIGTARP report.  First, as I emphasized in “It’s a Wonderful Life: AIG Edition,” if AIG hadn’t been born and hence not around to sell protection, the owners of the CDOs would have taken a bath.  Thus, it is not credit default swaps per se that were the ultimate source of the problem; it was the underlying CDOs.  Only to the extent that the existence of AIG contributed to a larger CDO market could CDS have contributed to the financial crisis.  Indeed, the crisis–that is, the losses suffered by big banks–could have been worse if AIG hadn’t taken a $50 billion hit.

Second, one of the narratives has been that AIG didn’t have to post collateral, and hence took on bigger positions than it would have if it had been required to do so.  It indeed didn’t post any initial margin, but it is clear that the deals contemplated the posting of collateral even absent an AIG credit event.  AIG had posted at least $22 billion in collateral prior to its downgrade (Table 1).  Perhaps the necessity of posting initial margin would have reduced AIG’s appetite, but likely not, in my view.  First, by not requiring original margin, counterparties were extending AIG credit, and presumably charged for it; only to the extent that it would have been costlier to finance initial margin payments would the posting of such margin have made AIG reduce its positions.  Second, given that it lost huge sums on mortgage backed in its security lending program and other operations, it is clear that AIG viewed these as very attractively priced risks.  Sure, a slightly higher cost (due to the necessity of posting initial margin) might have induced it to cut back some, but likely not very much.

To conclude: given the availability of another alternative to buying out the banks at 100 percent of par, that would not have required a cash payment, and the weak justifications for avoiding that option, make it highly likely that the AIG bailout was structured in part to provide liquidity to major banks (and perhaps, but not conclusively, one particular bank).  Which makes the Fed’s–and Geithner’s–denial that the financial health of these firms was an irrelevance highly dubious, not to say, a lie.

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Economic Policy

This is a guest post by The Golden Truth.

“U.S. Treasury Secretary Timothy Geithner said the government’s borrowing needs would be substantially less than expected”

If he made that statement in front of an audience of Chinese university students, he would have been laughed out of the auditorium.  I’m thinking he forgot to take the speech that Robert Rubin had prepared for him and he was ad-libbing.  Clearly, his tax-dodging was a result of a complete lack of math skills.  The arithmetic is pretty simple:  when the Government increases its spending at an increasing rate, and at the same time revenues fall off even more quickly (I guess that’s really simple calculus – sorry Tim), you have a situation which requires the Government to borrow at an increasing rate to make up for the gap between spending and revenues.

I guess if the Government were to pull out of Afghanistan, rescind the unemployment insurance extension, fire most of Obama’s useless Czars plus staff, cut off FNM, FRE, GM, C, AIG and its other corporate welfare projects, shelve Obama’s Stimulus 2…the list really goes on and on and on and on….I guess Tiny-Brain Tim could make a case that the U.S. might actually slow down its appetite for more Treasury debt and not look like a retard.

Until then Tim, stick with the speech your masters prepare for you.  Both you and your boss are terrible at speaking off-teleprompter.

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StocksFinancialAIGCGMFNMFRE

This article was originally published at Zero Hedge on September 15, 2009.

It was just yesterday that Tim Geithner was lying that banks are constantly increasing lending to consumers. Well, yet another lie refuted. Banks, and not just any banks, but those receiving government bail outs and subsidies, continued constricting lending in July, with total average loan balance outstanding declining by $54 billion from $4,295 billion to $4,241 billion, a 1.3% decline, following a 1.1% decline in June.

As for the reason why loan originations in July declined a whopping 10% after posting a 12.7% increase in June, the government simply noted that this was due to “decreased demand from borrowers.”

And so the circular lie continues: the government claims lending is increasing, when in fact, it is not, and when confronted with this fact, the government claims this is due to lack of interest. Furthermore, with retail sales reportedly higher, the consumer is allegedly spending more, with average wages declining, meaning consumer need to borrow to finance purchases, or else eat into their meager savings. Yet all this is occurring on the foreground of a rapidly increasing savings rate. So consumers are not borrowing, they are saving more, yet somehow sales are increasing: the lie is so circular that if there was a Kudlowbot, its head would explode trying to “spin” this null argument.

Last but not least, the primary politically correct reason for bailing out banks was to ensure that they can continue lending. So here are the numbers: $4,434.7 billion in loans outstanding in January, $4,241.4 billion in July: a 4.4% decline, which, all else being equal, would have to be offset by a comparable increase in the rate of savings. However, with wages declining and more and more people becoming unemployed, all else is anything but equal. At least bank CEOs get their precious bail out capital and golden parachute packages (ref: John Thain) as popular media outlets continue spinning lies and spewing factless propaganda.