Holiday Tonic III

December 23, 2009:

The bravest are surely those who have the clearest vision of what is before them, glory and danger alike, and yet notwithstanding, go out to meet it.

— Thucydides, History of the Peloponnesian War, Book II

Courage is not the absence of fear, but rather the judgment that something else is more important than fear.

— Ambrose Redmoon

You become a champion by fighting one more round. When things are tough, you fight one more round.

— "Gentleman Jim" Corbett

Woody Allen is often credited with saying something like eighty percent of life is just showing up. Sometimes—like during the economic horror show we have just lived through this past year—I think the point is simply to endure.

Hopefully, a little reflection will remind you just how many important things in your life are worth enduring for.

Happy and healthy holidays to you and your loved ones. Be good.

© 2009 The Epicurean Dealmaker. All rights reserved.

A Few Things Worth Considering

From one of the more underrated political philosophers and students of human nature of our time:

Governments, if they endure, always tend increasingly toward aristocratic forms. No government in history has been known to evade this pattern. And as the aristocracy develops, government tends more and more to act exclusively in the interests of the ruling class — whether that class be hereditary royalty, oligarchs of financial empires, or entrenched bureaucracy.

* *
Good government never depends upon laws, but upon the personal qualities of those who govern. The machinery of government is always subordinate to the will of those who administer that machinery. The most important element of government, therefore, is the method of choosing leaders.

* *
What you of the CHOAM directorate seem unable to understand is that you seldom find real loyalties in commerce ... Men must want to do things of their own innermost drives. People, not commercial organisations or chains of command, are what make great civilizations work, every civilization depends upon the quality of the individuals it produces. If you overorganize humans, over-legalize them, suppress their urge to greatness — they cannot work and their civilization collapses.

— Frank Herbert, Children of Dune

All laws and regulations are only as good as the people who create, interpret, and implement them. Given the dominant strains of careerism, materialism, and narcissism among our current socioeconomic elites, this observation falls squarely on the side of those who counsel cynicism and despair.

In the long run, the biggest challenge we face is not writing new laws and regulations, but rather choosing better leaders. We might approach this project first by figuring out how to raise better humans.

Ah, if only it were that easy ...

© 2009 The Epicurean Dealmaker. All rights reserved.

For Every Action ...

Christopher Columbus: "Hello there, hello there. Heh, heh. Ahh ... We white men. Other side of ocean. My name ... Chris-to-pher Co-lum-bus."
Indian chief: "Oh? You over here on a Fulbright?"
Christopher Columbus: "Hah? Uh, no, no. I'm over here on an Isabella, as a matter of fact. Which reminds me: I wanna take a few of you guys back with me in the boat to prove I discovered you."
Indian chief: "What you mean, discover us? We discover you."
Christopher Columbus: "You discovered us?"
Indian chief: "Certainly. We discover you on beach here. Is all how you look at it."
Christopher Columbus: "Ah, I never thought of that."

— "Columbus Discovers America," Stan Freberg Presents the United States of America, Vol. 1: The Early Years

It looks like Alistair Darling is going to have a quiet Christmas.

The UK finance minister unveiled a nasty Christmas surprise for bankers in the City yesterday: a 50%, non-deductible tax on discretionary bonuses in excess of £25,000 (or $41,000), to be levied against their employers' net income. This scurrilous government attack against chalk stripe suits, Soho strip clubs, and London property values landed with a sickening thud in Old Blighty. Many a banker's wife summarily cancelled their holiday plans and started contacting real estate agents in Geneva.

Today, Nicolas Sarkozy of France had the unmitigated gall (Unmitigated Gaul?) to pile on with a parallel policy proposal for his country's budget and an editorial in The Wall Street Journal, co-authored with famously dyspeptic Scot Gordon Brown. The fact that France agrees with the UK and is proposing a similar policy is proof positive that either La Republique has been secretly taken over by a stunted Englishman pretending to be French or the UK's Labour government is so desperate to retain power that it's turning Gaullist. Probably both.

In any event, the policy—as do all new tax policies at the end of the day—has triggered a desperate surge of scurrying about by bankers and banks, as they attempt to discover ways out of the trap. Their prospects do not look good.

London contacts report senior investment bankers stacked three deep on the pavement outside advisory boutiques' offices this morning, banging on the custom paneled mahogany doors to get entrance for interviews. One Vice President remarked he hadn't seen that many bespoke suits in one place since he stumbled into Gieves and Hawkes' basement storeroom on Saville Row by mistake. I predict independent UK advisors will quintuple their headcount by Christmas.

The bankers they don't hire will all get fired by their employers and rehired immediately with guaranteed bonuses—which are exempt from the new tax, for now—or put on retainer as fiendishly well paid independent contractors. The Freelancers' Association of Great Britain should see its membership rolls and dues receipts increase 10,000%, and HM Treasury will no doubt promptly reclassify it as a bank for tax purposes. The stately annual dance of new tax regulation, evasion, and counter-evasion will begin to resemble a cage match at the Ultimate Fighting Championships.

The only parties for whom this will be an unalloyed benefit will be tax lawyers, accountants, and corporate relocation specialists. Their spouses and families won't see much of them over the Christmas holiday, but at least they'll be able to console themselves with frozen rum punch and figgy pudding in £10,000-per-night suites on St. Barts.

* * *

Despite all the frantic squealing by outraged bankers, it is clear the UK government enacted this policy not to "recapture" excess compensation from individual employees through personal taxation, but rather to dissuade banks from paying more than nominal bonuses at all. Instead, it wants them to use the money they save to bolster their weakened balance sheets. Chancellor Darling could not have been clearer:

“I’m giving them a choice. They can use their profits to build up their capital base, but if they insist on paying substantial rewards, I’m determined to claw money back for the taxpayer,” he said.

And, as the following little spreadsheet indicates,¹ he plans to do this by making banks choose between their employees and their shareholders:

Given a hypothetical bank with operating profit before discretionary compensation of one million pounds and one employee which management intends to pay half a million quid, the three rightmost columns show the effect on both employee and net income under the new policy under three different scenarios. Under the first, "equal bonus" scenario, the employee still walks away with his £500,000 pre-tax bonus, but instead of earning £360,000 as before, shareholders take a 66% hit to net income, to £122,500. Under the second, "equal net income" scenario, bank management preserves shareholder income at the pre-policy level of £360,000, but the banker walks away with 39% fewer pre-tax shillings. Finally, in the third, "equal pain" scenario, the bank tries to share the pain of the new policy equally between employees and shareholders, and each take a 24.5% hit to their earnings.

Of course, a stubborn bank could go right ahead and pay full discretionary bonuses to its employees, and under the new policy HM Treasury would drain half the excess straight out of the bank's equity account. This hardly seems conducive toward strengthening capital ratios in the financial sector, however. Presumably the government is relying on bank shareholders to scream bloody murder should management try this, not to mention bank creditors, who will scowl with disapproval as their obligors' creditworthiness looks to sneak out the door to a Ferrari dealership in the pockets of its employees.

Interestingly enough, this scenario is also one in which HM Treasury maximizes its own tax receipts, from the personal income and National Insurance tax paid by individual bankers on larger bonuses plus the direct corporate tax on excess bonuses. The silly thing about such a scenario, however, is that the UK government would be far more likely to have to plow its higher tax revenues right back into the newly weakened banking sector in the form of more direct support. Talk about a "doom loop."

Another complicating factor in this whole discussion is that employees often make up a substantial portion of their employer's shareholder base, especially at investment banks. At the extreme, if a bank had only one employee who also happened to be the sole shareholder, a proper tax minimization strategy would be to forgo a discretionary bonus entirely and book that amount into net income. This is because the standard UK corporate rate of 28% is far less punitive than the new 50% top personal rate for high earners, plus National Insurance deductions. But how would Mr. Eddington-Smythe pay his local grocer? Borrow money from his employer, perhaps? Oops, there goes the leverage ratio again.

* * *

On this side of the pond, the evil genius cephalopods at Goldman Sachs have come up with a different approach. The firm announced today that its 30 top executives will take all their discretionary compensation this year in the form of restricted stock, which they cannot sell for five years.

In principal, this strategy actually makes more sense than the UK tax policy does in terms of bolstering banks' and investment banks' balance sheets. For one thing, it implicitly acknowledges that a bank probably should pay something more than a £25,000 bonus to highly productive employees if it expects to keep them, and it puts no explicit upper limit on that pay. For another, it conserves the gajillions in cash a bank would otherwise pay out in bonuses and replaces it with common stock, and unvested common stock at that. That bolsters both the cash and shareholders equity accounts by the amount of deferred bonuses and strengthens the company's credit position. Furthermore, as I have pointed out before, bankers who receive deferred stock compensation are the best kind of shareholders to have, from a credit standpoint, because they are involuntary, long-term providers of permanent capital. No high frequency traders, these.

However, it's worth noting that as announced this policy only applies to the thirty Executive Committee members at the Squid. So, while it may conserve $300 or so million extra cash which would otherwise have been paid out as the cash portion of these executives' bonuses under prior policy, it says nothing about the up to $10 billion in cash which could presumably get sucked out the window in the pay packets of its non-executive employees. As a public relations stunt, and a sop to Congressmen and other populists on the warpath, it is genius, and Lloyd Blankfein and the other 29 sacrificial lambs probably have enough liquidity to weather the privation. But as a credit bolstering event for Goldman Sachs, it probably nets out close to a wash.

In addition, Goldman's new policy carries a real cost, too: increased dilution for non-employee shareholders. For, as our hypothetical little exercise above should have illustrated, there is a natural struggle over the spoils within a bank between its employees and its outside shareholders. The Goldman announcement makes no disclosures on this topic, but I can assure you top management is having heated discussions with major shareholders right now over just how many basis points of net revenue will go to investors and how many to the hired help.

* * *

This argument may be quite interesting to the parties involved—and their wives, mistresses, and household staff—but it has little practical import for those of us on the outside looking in. In fact, strong arguments can and have been made that an excessively large portion of the filthy lucre Goldman and other US banks' investors and employees are arguing over this year doesn't properly belong to them. A huge portion of the outsize sales and trading profits which have been fattening domestic banks' income statements is due to cheap funding provided both directly and indirectly by the government, direct subsidies from the US taxpayer, and the selective elimination of industry competitors through direct and indirect government action during the height of the financial crisis.

People who object to this situation claim the only sensible thing to do is for the taxpayers to claw back a chunk of these profits in the form of a windfall profits tax. Properly designed, such a tax would be levied against operating profits before compensation expense. Then, taxpayers would get back a portion of the outright subsidy they have been handing to the bankers, and bank employees and outside shareholders would be free to squabble over the remainder. The biggest challenge here, of course—apart from worrying about how to prevent politicians from making a temporary windfall profits tax permanent—would be to determine the proper amount of subsidy, and hence tax, to recover. The answer will always be somewhat arbitrary at the end of the day, but there is no reason a sensible number could not be figured out by a couple of accountants with a calculator and a bottle of scotch.

* * *

In any event, the policy tensions both here and abroad are clear: do we want banks to reduce employee payouts, retain capital, and bolster their weakened balance sheets, or do we want reparations of unearned, "excess" profits in the form of corporate, personal, or windfall profits taxes to the public purse? For conundrums like these, we have few instruments available except tax policy. But tax policy is a blunt instrument, and it acts on the economy a lot like a water balloon: every time we squeeze one end, the other end swells up bigger than before.

Moreover, I am sad to say that all available evidence seems to indicate our water balloon is a whoopee cushion, too.

¹ Please, please, UK types—especially accountants and tax advisers—cool your jets. I know this example is a gross oversimplification, and it simply does not reflect all the relevant details, the intense value added which you and your firm can bring to the discussion with your extensive expertise, blah, blah, blah. It is meant to illustrate a relatively simple point, for which task I believe it is perfectly adequate. As usual, regular readers of this site know not to take my scribblings seriously in any respect, much less in the cloistered thickets of taxation and accounting.

© 2009 The Epicurean Dealmaker. All rights reserved.

We Didn't Start the Fire

Rob Slolom: "Wow. Eight Oscars, 400 million dollars at the box office, and you saved Tugg Speedman's career."
Les Grossman: "I couldn't have done it without you."
Rob Slolom: "Really?"
Les Grossman: "No, dickhead. Of course I could. A nutless monkey could do your job. Now, go get drunk and take credit at all the parties."
Rob Slolom: "I wouldn't do that."
Les Grossman: "Ah ... joking. "
Rob Slolom: "Ah, there he is! Funny. You're a funny guy."
Les Grossman: "Yeah. But seriously, a nutless monkey could do your job."

— Tropic Thunder

For what it is worth, O Dearly Beloved, you cannot count me among the rabid, spittle-flecked populists who lump private equity plutocrats in with venal investment bankers, clueless commercial bankers, meretricious mortgage brokers, and Nancy Pelosi's manicurist as the principal agents of our current economic desuetude. While it is true that many of these would-be Captains of Industry did purchase companies at preposterously high valuations in 2006 and 2007 at the orgiastic climax of the Sino-Greenspan credit bubble, the most the majority of these hapless boobs can be accused of is getting their wee-wees caught in the woodchipper of mistaken opportunity.

Vast herds of professional morons in the fixed income investor community apparently thought it was a brilliant idea to offer virtually limitless quantities of debt at virtually invisible interest rates with virtually zero credit protection to picayune ex-investment bankers so the latter could snap up the flower of American (and global) industry at 250% of retail. With limited exceptions, said PE types said "What the hell," and signed on the dotted line. After all, their fiduciary and professional duty to their own investors is simply to maximize returns on contributed capital. And, in the unexpected case their investments went belly up, the PE professionals and their limited partners could just hand over the keys to the failed portfolio companies to their embarrassed lenders. What was not to like?

Of course, many of the overlevered companies owned by private equity firms are now struggling or have failed entirely. Hundreds if not thousands of employees who worked at these investments have been laid off, and thousands if not millions of citizens whose pension funds or universities invested in their shitty debt have taken it in the neck. But caveat emptor, eh?

Like many other participants in the Great Financial Clusterfuck of 2008, private equity professionals helped make things worse for everybody through the unholy combination of personal greed, institutional incentives toward excessive debt, and general shortsighted arrogance, but they did not cause the crisis. Furthermore, I do believe the version of the private equity model which focuses on making substantive operational and strategic improvements to portfolio companies—rather than just levering them up the wazoo and hoping for the best—is a valid and effective alternative investment strategy in this economy. Many companies can be materially improved by the tender ministrations of a cigar-chomping five-foot-four inch sadist who would just as soon waterboard a manager as look at him. And they were.

* * *

Paragons of Sweat Equity Capitalism or not, private equity professionals are coming under the legislative microscope along with all the other financiers and hangers on who wear suits that cost more than the average Congressman's car. But in their case, the focus of regulatory reform is taxation, particularly that form of personal taxation peculiar to our hobbyist industrialists and known to all and sundry as carried interest.

I will let Floyd Norris explain:

The “carried interest” tax break lets private equity partners claim that their compensation is really long-term capital gains, since they are allocated percentages of the profits earned by their investments.

The Ways and Means Committee wants to end that, and today a trade group, the Private Equity Council, protested:

“Raising taxes on growth investments by private equity, real estate and many other partnerships just doesn’t make sense — particularly in this time of fragile economic recovery and continuing joblessness. By more than doubling the tax rate, the carried interest proposal will discourage investment; deprive many American businesses of the capital they need to survive and grow; and jeopardize critical job creation opportunities.”

Uh, no. I call bullshit.

We have been down this goat path before (masochists see "Related reading," below), and I remain utterly unconvinced that raising the personal taxes of a couple thousand billionaires, multi-millionaires, and would-be millionaires on the fruits of their labor would have any effect whatsoever on the ability of corporations to find private equity backers for their businesses. After all, the entities which provide approximately 95% of the equity which these Scrooge McDucks play with—pension funds, university endowments, and other large institutional investors—are either tax exempt or completely indifferent to the plight of their PE portfolio managers. And if a couple hundred of these quackers decide to take their (relatively) paltry marbles off the table and stalk off in a huff to endless champagne and chlamydia on the French Riviera, I don't think anyone will miss them.

Then there's the whole "fairness" issue. I will let Mr. Norris expound his view:

Personally, I am not sure that capital gains should get tax breaks anyway. But for private equity partners, who are earning huge sums of money by their skill at investing other people’s money, it seems particularly inappropriate. They earn money from their labor, just like the rest of us.

May I suggest a simple rule to be considered by Congress. “No executive should pay a lower tax rate than the rate paid by the person who cleans the executive’s office.”

There, that should set a few sardonic memoirists' blood boiling.

* * *

On the other hand, I seem to recall reading that the CBO estimated the aggregate proceeds to Treasury from taxing Steve Schwarzman and his fellow übermenschen like normal human beings would only amount to a few billion dollars over several years. So it's not like we're gonna recover the money we've pissed down the drain at Citibank and AIG by picking Henry Kravis's pocket. But then again, every dollar counts, and if I can avoid paying a few more shekels in taxes because we decide to stop treating pencil-necked MBAs like Andrew fucking Carnegie, I will be more than satisfied.

And if the private equity plutocrats don't like it, I would point them to the immortal words of yet another flaming asshole of my acquaintance: "That's baseball."

Related reading:
Tax Breaks for Everyone! (June 14, 2007)
J'accuse (June 15, 2007)
J'accuse, Part Deux (June 27, 2007)
The Taxman Cometh (July 11, 2007)
B(ogus Ta)X (July 13, 2007)

© 2009 The Epicurean Dealmaker. All rights reserved.

All Hail the New Decembrists

Trot on over, kiddies, to Your Curmudgeonly Blogosopher's new blog site, The New Decembrists, if you get half a mo'.

It is subtitled "A Public Forum for the Discussion of Financial Regulation and Reform," and, by golly, that is what it is intended to be. While Yours Truly remains for now the sole editor and inspiration for the site, I hope and expect many other contributors, commenters, and gadabouts will join the conversation about one of the more important topics of our time. While I have encountered many interesting posts, articles, and conversations about the topic of financial regulation and reform on the web, these seem to be scattered about and difficult to find. The new site is designed to be a clean, well-lighted place for all such ruminations to gather, if not in peace, then at least under one roof.

Aficionados of this site will be intrigued to learn that The New Decembrists will welcome comments, as long as they are on-topic, at least vaguely intelligent, and/or stylishly amusing. Sadly, I have no current intent to change my no-comment policy here. This is because, while I freely admit to not knowing everything there is to know about financial regulation and reform—and hence am happy to invite the thoughts of others at TND—I am unshaken in my belief that I know absolutely everything else. Allowing my Faithful Readers to comment here would merely encourage you to tell me things I already know or embarrass yourself needlessly.

Never let it be said, Dear Friends, that I am not always looking out for your welfare.

© 2009 The Epicurean Dealmaker. All rights reserved.

A Reformist Manifesto

The Communists disdain to conceal their views and aims. They openly declare that their ends can be attained only by the forcible overthrow of all existing social conditions. Let the ruling classes tremble at a Communistic revolution. The proletarians have nothing to lose but their chains. They have a world to win.

Working Men of All Countries, Unite!

— Karl Marx and Friedrich Engels, Manifesto of the Communist Party

It has not escaped my notice, O Estimable and Valued Readers, that you have displayed remarkable patience with Your Dedicated Correspondent over the last many moons of the ongoing financial crisis and its aftermath. I have ranted, I have railed, and I have hopped up and down spluttering like a one-legged kangaroo rat on a hotplate over the many failures of our present regulatory system to have avoided or even anticipated the financial tsunami which rolled over us. "Sure," I have seen you mutter to yourself, "TED has fulminated rather spectacularly about what went wrong, and how idiots, nincompoops, and boobs of every stripe screwed the pooch, but what does he suggest? Does he have any ideas, or is he merely content to take potshots at financiers, regulators, and politicians and leave it at that?"

This is a fair question, and I think you deserve an definitive answer. Being none other than who I am, however, you can rightly expect that I will give it to you with both barrels. Subtlety and nuance be damned.

I know full well what I propose is at least a bridge too far, a utopian dream doomed to ignominious death in the fetid swamp of pragmatism, special interests, and meretricious compromise which poses as our vaunted Legislative Branch. A death by a thousand cuts, each made ruefully and reluctantly by unimpeachably reasonable men and women who sport weary smiles and practiced shrugs. Men and women who explain "That's just how it is," or murmur an even simpler answer: "Politics."

But even given this—given that commentators and politicians alike have been writing fulsome obituaries for financial reform since before the first draft sprang aborning from the pen of some Congressional aide—one can still ask why should we not aspire to more? Why should we not try to map out the right answer to our problems first? The simple answer, the clear answer? Then, after we have gotten our bearings, we can debate and argue until the cows come home about the details, the practicalities, and the unintended consequences we want to forestall. Right now, all this debate—if it is taking place at all—is being conducted in the back halls, offices, and lobbies of Capitol Hill, out of public view, by the self-interested financial parties we seek to regulate and the craven legislators who hold themselves in thrall to them.

This is no way to reform our financial system, much less run a representative democracy.

* * *

So let me slap some markers on the table, in the interest of public service. These are concrete ideas which have occurred to me over the course of listening, reading, and participating in the debate over regulatory reform over the last many months. I claim no originality for these ideas, and I cheerfully admit that most if not all have already been put forth by thinkers and writers who are cleverer, better educated, and more eloquent than me. If I can claim credit for anything here, it is in laying out the best of these ideas in the most extreme form. Let us set the perimeter of the debate, and the dimensions of the playing field, before we start arguing over the color of the contending teams' jerseys.

In no particular order, here we go.

1) Ban political campaign contributions by the financial industry. We currently have the best politicians money can buy. I suspect it might be conducive toward better governance should this channel of undue influence be severed. Can you disagree?

2) Narrow and focus the role of the Federal Reserve. The Fed should continue to focus on monetary policy, price stability, and employment. It should add responsibility for monitoring, controlling, and managing systemic financial risk. Of all existing or potential regulatory entities, the Fed is best placed to do the latter. On the other hand, it has failed pathetically to protect consumers, control derivatives, or manage mortgage markets. These and any other non-core duties should be summarily stripped from it. Focus, focus, focus.

3) Render Fed actions and deliberations transparent. Secrecy runs counter to the public weal. Impose a delay of three months, six months, or whatever, but open the minutes of all material Fed actions and decisions to public scrutiny after the fact. This is called accountability, and the Fed must not be immune from it.

4) Consolidate all banking supervision under one unified national regulator. No more "regulator shopping." No more races to the bottom. Should there be real functional and regulatory differences among thrifts, savings and loans, small local and regional banks, and large money center behemoths, I am sure our clever regulators can make the distinction and set up appropriately diverse and differentiated regulatory regimes. Just do it under one roof, I beg you. I have heard no defensible reason whatsoever why this does not make sense.

5) Create a separate, independent consumer financial protection agency charged with regulating all consumer financial products and services. Regulating consumer or retail financial services is different in kind from regulating wholesale or institutional products. Among other things, consumers need protection in a way institutions do not. There is absolutely no reason why consumer protections should not be monitored by a single, dedicated regulator. If it has to do with money, and consumers, this entity should regulate it. In addition to improving the position of ordinary citizens vis á vis their financial service providers, unitary regulation of this field should encourage consumer-friendly innovation across products and services, since there will be only one regulator to deal with. The only long-term question is why this entity should not take over the consumer protection functions of the SEC when it comes to securities and markets. (My answer: it should.)

6) While we're at it, why not create a national insurance regulator? Honestly, the current state-by-state regulation of insurance companies is preposterous, and massively consumer unfriendly. At base, insurance is a very simple business, and consumer choice and value should be improved by national consolidation. Why should this be an issue of states' rights? Anyone? Anyone?

7) Create an integrated regulator of wholesale and institutional financial markets. Merge the SEC and the CFTC. Bolster its combined budget. Make broker dealers and other regulated entities provide operating funds through levies. Upgrade its systems, procedures, and personnel. Double or triple its professionals' pay, and impose a minimum five-year ban on joining any financial services provider after leaving the agency. Increase accountability, esprit de corps, and morale. Hire leaders who are dedicated to turning it into an agency everybody wants to join, instead of a laughingstock. Destroy all evidence that Christopher Cox ever darkened its doors.

8) Register and monitor hedge funds. Honestly, are we going to quibble about collecting information in this space? For what, compliance and reporting fees which will add up to less than Steve Cohen spends on Chunky Monkey ice cream every month?

9) Force virtually all over the counter derivatives onto exchanges and clearinghouses. This will increase visibility, improve netting and credit relationships, bolster systemic stability, and lower costs in most instances. (More information = lower prices.) Exceptions for highly customized OTC derivatives and/or pure end-user hedging instruments should be made on a product-by-product and case-by-case basis. If nothing else, such a regime would have enabled counterparties, regulators, and other market participants to have seen stupid, reckless, unlimited naked-put writers like AIG Financial Products coming from a mile away. How, exactly, will greater transparency and easier margin and credit control increase costs in these markets? They won't. Disagree? Prove it.

10) Simplify and rationalize Congressional oversight of financial regulators. No more oversight of financial derivatives by the Agriculture Committees, I beg you. Pretty please?

* * *

Please note that I say nothing about the particular policies which these new entities should create or enforce. Nothing about the critical issues of maximum leverage, separation of commercial, retail, and investment banking, compensation, or explicit limits on firm size or connectivity. This is intentional.

While I have some firm opinions on the right answers to many of these questions, I think it is far more important to set up strong, competent, and well-informed regulators for the financial sector than to worry about policy particulars right now. For one thing, our current regulators simply do not have enough information or understanding about the current financial system to start making those kinds of decisions. And I think most reasonable observers would agree the financial system is dynamic enough to render static regulation by explicit legislation impractical, if not downright dangerous. Set up strong regulators with clear mandates and well-defined duties, and they will come up with the right policies. What we need to do now is sever some of the improper and counterproductive patterns of influence that have hobbled regulators in the past and let the overseers of the system do their job.

Simplify, simplify, simplify. The global financial system is complicated enough as it stands. We should not render its overseers' jobs more difficult by forcing their activities into outdated, counterproductive patterns designed three quarters of a century ago for a far simpler time. Sure, many of the very same professionals and regulators who fucked up so comprehensively last time will be hired into the same roles at the same or different institutions. These brand new spanking institutions themselves will be vulnerable to the same bureaucratic sclerosis, political and ideological pressures, and civil service mentality which afflicted their predecessors. But it's time to shake things up, to clear away the underbrush, and to make a clean break with the past.

And if our elected representatives in Washington are incapable of doing this, then perhaps it is time we took to the barricades ourselves.

If I had my way
If I had my way
If I had my way
I would tear this old building down

— The Grateful Dead, Samson and Delilah

What are your thoughts, Dear Readers? I am listening.

© 2009 The Epicurean Dealmaker. All rights reserved.

Charitable Giving

"Guess what? I have flaws. What are they? Oh I dunno, I sing in the shower? Sometimes I spend too much time volunteering. Occasionally I'll hit somebody with my car. So sue me—no, don't sue me. That is opposite the point I'm trying to make."

"Do I need to be liked? Absolutely not. I like to be liked. I enjoy being liked. I have to be liked. But it's not like this, compulsive, need, to be liked. Like my need to be praised."

— Michael Scott, The Office

In an otherwise less than sympathetic piece on the public relations travails of the Vampire Squid everybody loves to hate, Financial Times journalist Chrystia Freeland credits the investment bank's recently announced 10,000 Small Businesses initiative as "cleverly conceived" and "designed for maximum effect." I have to disagree.

Like many of you, I am sure, I was impressed when I heard Goldman was going to donate $500 million to a myriad of small businesses, which are widely perceived to be the primary engines of job creation in our economy. Oh goody, I thought: half a billion bucks mainlined into the veins of those businesses best able to kick start the economy back into rude health. What a coup.

Then I read the blasted thing. It is not pretty. Sixty percent of the committed funds will be distributed for "lending and philanthropic support," but this will be directed through "Community Development Financial Institutions." Call me a skeptic, but this does not sound like high powered money coursing directly into the working capital accounts of productive enterprises which can use it. Instead, it sounds like a $300 million slush fund for the functional equivalent of community NGOs. The remaining forty percent—200 million clams—will go toward "education."

Oh great, Lloyd, that's just what every small businessman needs: an education. After all, everybody knows what the owner of a chain of dry cleaners or a machine tool factory really needs is "scholarships," greater "educational capacity," and mentoring by some half-assed social worker out of an abandoned storefront. Why stop there, though? Why not endow a hundred spots at Harvard Business School in perpetuity so Hmong immigrants can learn to apply CAPM and discounted cash flow analysis to their corner delicatessens? ¹

Either that, or you could pull your head out of your ass and actually lend some money to these guys instead. Heck, set up a small business lender with half a billion in capital, lever it up ten to one, and loan five billion dollars out to struggling small businesses. You might actually spur some real economic growth, rather than employing an army of aspiring bureaucrats to fill out scholarship applications in triplicate. Plus, you might finally earn some respect from a country which suspects you and your peers are constitutionally incapable of taking a crap without consulting the Harvard Business Review or the McKinsey Handbook of Corporate Obfuscation for instructions. ²

This idea scales attractively, too: Put in a billion of equity, and loan out ten billion, and people might even stop whispering disparaging remarks about the size of your junk in the corridors of Capitol Hill. Now there's a return on capital.

* * *

On the other hand, given that you run an investment bank, if you want to raise some serious money for charity, you could always open a Swear Jar. Just make sure it's big enough.

¹ Well, okay, that was a cheap shot. You and I both know doing any such thing would destroy the exclusivity and aura of an HBS education, which would be a societal catastrophe too terrible to contemplate. (Not to mention wasting two years out of the lives of otherwise productive elements of the economy.) Just kidding, bro.
² I mean really, who comes up with this shit? I know you couldn't give a damn about tiny ass businesses which will never grow large enough to become paying customers of your firm, but you are theoretically announcing this program for public effect, no? Why not make it clear, simple, and understandable, instead of a convoluted, bureaucratic mess apparently derived from some EU functionary's wet dream? Bank? Lending? Ring a bell?

© 2009 The Epicurean Dealmaker. All rights reserved.

Compassion Fatigue

"No matter how many times you save the world, it always manages to get back in jeopardy again. Sometimes I just want it to stay saved, you know? For a little bit? I feel like the maid: 'I just cleaned up this mess! Can we keep it clean for ... for ten minutes?!'"

— The Incredibles

I don't know about you, Dear and Long-Suffering Readers, but I am beginning to worry about Yves Smith.

The indefatigable blogger and soon-to-be-published author is really showing the strain of commenting from the front lines of the global financial crisis, as she has done, admirably, from the very beginning. Today, she lit into Neil Barofsky's SIGTARP post mortem on the New York Fed's disbursement of billions of taxpayer dollars to cancel credit default swaps written by the pathetic boobs at AIG. AIG sold those swaps, you may remember, under the cheerfully naive assumption that, as long as you hold a AAA credit rating and employ a bunch of overpaid financial engineers in a fancy office on Curzon Street, you can write as many naked puts on as much toxic crap as you like with no consequences. Much as I would be delighted to learn otherwise, I believe we may safely consider that presumption to be dead, buried, decayed, mixed into topsoil, and completely absorbed into the Earth's mantle via tectonic subduction by now.

In the meantime, however, the rest of us continue to live with the consequences of AIG's tomfoolery, and Ms Smith remains understandably upset about this state of affairs. So much so, in fact, I think she rather unfairly pans Mr. Baroksky's report as unacceptably timid and mealy-mouthed. I read her to say she would rather have the report blast the Fed's mishandling of the AIG crisis in no uncertain terms, not sugarcoat its misdeeds in the bland and unoffensive coating of bureaucratese.

But this is unfair. From my perspective—known to most of you as distinctly unappreciative of the Fed's spineless and inept handling of this imbroglio—I think Barofsky and pals did a rather bang-up job of blowing holes in both the government's actions and their pathetic ex post rationalizations therefor. You just have to read between the dry, measured lines a little.

* * *

As witness, I offer for your reading pleasure select excerpts from the Conclusions and Lessons Learned section of the report, with a few helpful explanatory titles and glosses of my own design.

Page 28: "Plan B? What Plan B?"

— or —

The New York Fed Conclusively Demonstrates It Cannot Plan Its Way Out of a Paper Bag, Even with a Map and a Blowtorch

When first confronted with the liquidity crisis at AIG, the Federal Reserve Board and FRBNY, who were then contending with the demise of Lehman Brothers, turned to the private sector to arrange and provide funding to stave off AIG’s collapse. Confident that a private sector solution would be forthcoming, FRBNY did not develop a contingency plan; when private financing fell through, FRBNY was left with little time to decide whether to rescue AIG and, if so, on what terms. ... Not preparing an alternative to private financing, however, left FRBNY with little opportunity to fashion appropriate terms for the support, and believing it had no time to do otherwise, it essentially adopted the term sheet that had been the subject of the aborted private financing discussions (an effective interest rate in excess of 11 percent and an approximate 80 percent ownership interest in AIG), albeit in return for $85 billion in FRBNY financing rather than the $75 billion that had been contemplated for the private deal. In other words, the decision to acquire a controlling interest in one of the world’s most complex and most troubled corporations was done with almost no independent consideration of the terms of the transaction or the impact that those terms might have on the future of AIG.

This bang-up example of tactical thinking and mental flexibility, of course, led directly to a threatened downgrade of AIG by the ever-helpful credit rating agencies, which in turn made it absolutely necessary for AIG to get out from under those nasty, collateral-sucking CDSs. This allowed the Fed staffers a stellar opportunity to affirm their collective membership in the phylum Platyhelminthes (spineless flatworms) by halfheartedly negotiating for haircuts on the CDOs underlying AIG's swaps with its recalcitrant counterparties.

Apparently, the sum and substance of these negotiations was remarkably similar to that which my bloggish antagonist Economics of Contempt rather presciently proposed just recently:

AIG: "Would you be willing to accept, say, 70 cents on the dollar?"
Goldman: "No."

THE END

I kid you not.

Seven of AIG's largest counterparties—including, for the two which were French, that beacon of unfettered capitalism and bastion against tortious interference in contract law, the Government of Fucking France—told the Fed to go pound sand. The eighth, UBS, showed a deplorable lack of principle by venturing to offer a 2% haircut to its position, as long as everyone else did. Nevertheless, the Fed decided that friends don't let friends make insultingly small unilateral concessions where the US taxpayers' dime is concerned, so they just told them to forget it.

Mr. Barofsky picks up the narrative from here:

Page 29: "Integrity Is Our Watchword"

— or —

For Some Unexplained Reason, Perhaps Having to Do with Sunspots or the Phase of the Moon, the Institution Which Presided Over the Botched Fire Sale of Bear Stearns and the Clusterfuck Incineration of Lehman Brothers Magically and Unexpectedly Decides to Grow a Pair of Testicles Adopt a Set of Principles

In pursuing these negotiations, FRBNY made several policy decisions that severely limited its ability to obtain concessions from the counterparties: it determined that it would not treat the counterparties differently, and, in particular, would not treat domestic banks differently from foreign banks — a decision with particular import in light of the reaction of the French bank regulator which refused to allow two French bank counterparties to make concessions; it refused to use its considerable leverage as the regulator of several of these institutions to compel haircuts because FRBNY was acting on behalf of AIG (as opposed to in its role as a regulator); it was uncomfortable interfering with the sanctity of the counterparties’ contractual rights with AIG, which entitled them to full par value; it felt ethically restrained from threatening an AIG bankruptcy because it had no actual plans to carry out such a threat; and it was concerned about the reaction of the credit rating agencies should imposed haircuts be viewed as FRBNY backing away from fully supporting AIG. Although these were certainly valid concerns, these policy decisions came with a cost — they led directly to a negotiating strategy with the counterparties that even then-FRBNY President Geithner acknowledged had little likelihood of success.

The first, of course, is my personal favorite, for there is absolutely no tactic more effective at gutting whatever leverage and flexibility you might have in a negotiation—other than shoving a fragmentation grenade up your ass and pulling the pin—than refusing to treat different counterparties differently. I remember hearing hints of this preposterous limitation in earlier accounts of the AIG fiasco, but the Fed always seemed to imply it was a legal restriction inherent in its charter. Now, perhaps, we learn differently:

FRBNY’s decision to treat all counterparties equally (which FRBNY officials described as a “core value” of their organization), for example, gave each of the major counterparties (including the French banks) effective veto power over the possibility of a concession from any other party. This approach left FRBNY with few options, even after one of the counterparties indicated a willingness to negotiate concessions. It also arguably did not account for significant differences among the counterparties, including that some of them had received very substantial benefits from FRBNY and other Government agencies through various other bailout programs (including billions of dollars of taxpayer funds through TARP), a benefit not available to some of the other counterparties (including the French banks). It further did not account for the benefits the counterparties received from FRBNY’s initial bailout of AIG, without which they would have likely suffered far reduced payments as well as the indirect consequences of a potential systemic collapse.

Oh, yeah, that was a real winner.

Also in the winner column was the Fed's newly discovered squeamishness about playing hardball. Where the fuck did that come from? Mr. Barofsky needs no gloss on this topic (pp. 29–30):

Similarly, the refusal of FRBNY and the Federal Reserve to use their considerable leverage as the primary regulators for several of the counterparties, including the emphasis that their participation in the negotiations was purely “voluntary,” made the possibility of obtaining concessions from those counterparties extremely remote. While there can be no doubt that a regulators’ inherent leverage over a regulated entity must be used appropriately, and could in certain circumstances be abused, in other instances in this financial crisis regulators (including the Federal Reserve) have used overtly coercive language to convince financial institutions to take or forego certain actions. As SIGTARP reported in its audit of the initial Capital Purchase Program investments, for example, Treasury and the Federal Reserve were fully prepared to use their leverage as regulators to compel the nine largest financial institutions (including some of AIG’s counterparties) to accept $125 billion of TARP funding and to pressure Bank of America to conclude its merger with Merrill Lynch. Similarly, it has been widely reported that the Government, while arguably acting on behalf of General Motors and Chrysler, took an active role in negotiating substantial concessions from the creditors of those companies.

Gee, that sounds familiar.

* * *

Of course, then there is the whole "backdoor bailout" question, which arguably lies at the core of the persistent conspiracy theories percolating through our troubled polity.

Page 30: "No, No, No. I Didn't Give You That Dollar, I Gave You This Dollar"

— or —

The Fed Attempts to Gauge Exactly How Stupid 310 Million Americans Really Are by Denying the Fungibility of US Currency

Questions have been raised as to whether the Federal Reserve intentionally structured the AIG counterparty payments to benefit AIG’s counterparties — in other words that the AIG assistance was in effect a “backdoor bailout” of AIG’s counterparties. Then-FRBNY President Geithner and FRBNY’s general counsel deny that this was a relevant consideration for the AIG transactions. Irrespective of their stated intent, however, there is no question that the effect of FRBNY’s decisions — indeed, the very design of the federal assistance to AIG — was that tens of billions of dollars of Government money was funneled inexorably and directly to AIG’s counterparties. Although the primary intent of the initial $85 billion loan to AIG may well have been to prevent the adverse systemic consequences of an AIG failure on the financial system and the economy as a whole, in carrying out that intent, it was fully contemplated that such funding would be used by AIG to make tens of billions of dollars of collateral payments to the AIG counterparties. The intent in creating Maiden Lane III may similarly have been the improvement of AIG’s liquidity position to avoid further rating agency downgrades, but the direct effect was further payments of nearly $30 billion to AIG counterparties, albeit in return for assets of the same market value. Stated another way, by providing AIG with the capital to make these payments, Federal Reserve officials provided AIG’s counterparties with tens of billions of dollars they likely would have not otherwise received had AIG gone into bankruptcy.

And, lastly, the SIGTARP report blasts the Fed's continued ridiculous insistence on complete confidentiality for its actions, even in retrospect. Given the revelations we have been privileged with, I can only assume the Fed's diffidence has far more to do with covering up its massive, multidimensional incompetence in dealing with AIG than with any other purpose.

Page 31: "Transparency? We Don't Need No Fucking Transparency!"

— or —

Sunlight Is the Best Disinfectant, But Only for Those Other Guys

Second, the now familiar argument from Government officials about the dire consequences of basic transparency, as advocated by the Federal Reserve in connection with Maiden Lane III, once again simply does not withstand scrutiny. Federal Reserve officials initially refused to disclose the identities of the counterparties or the details of the payments, warning that disclosure of the names would undermine AIG’s stability, the privacy and business interests of the counterparties, and the stability of the markets. After public and Congressional pressure, AIG disclosed the identities. Notwithstanding the Federal Reserve’s warnings, the sky did not fall; there is no indication that AIG’s disclosure undermined the stability of AIG or the market or damaged legitimate interests of the counterparties. The lesson that should be learned — one that has been made apparent time after time in the Government’s response to the financial crisis — is that 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. While SIGTARP acknowledges that there might be circumstances in which the public’s right to know what its Government is doing should be circumscribed, those instances should be very few and very far between.

* * *

In fact, reading through this report, I find very little evidence that Barofsky et al. were even remotely swayed by the transparent nonsense the Fed used to justify its idiocy. Sure, they included it in their report, as they were no doubt required to do, but their conclusions seem remarkably impervious to the Fed's perspective.

And, weasel words aside, I read the SIGTARP report and find complete confirmation of two important points. First, the New York Fed, led by our current Secretary of the Treasury, botched the rescue of AIG so completely and so pathetically that it does border, as Yves says, on criminal incompetence. Second, the Fed had enough negotiating leverage in the entire affair to have substantially lessened the amount of taxpayer funds it ending up paying to AIG's counterparties, to the tune of billions and billions of dollars. A competent and motivated negotiator could have extracted billions of dollars in concessions with little else. But the Fed squandered that leverage, and it explicitly renounced several situational and structural advantages it possessed that contributed to that leverage, in the service of ... what, exactly? Certainly not in the service of its fiduciary duty to the American people, which cannot and should not be limited simply to the ad hoc preservation of a bunch of systemically important financial institutions.

Sadly, the horse has left the barn, the barn has burned down, and the farmer's wife has run off with the village idiot. I fear there is little upside in further speculation on what might have been. Suffice it to say, however, that I think Michael Moore should add a coda to his recent movie, Capitalism: A Love Story. In my vision, the chubby provocateur will pull his rented armored truck up to the steps of the Federal Reserve Bank and start chanting into his bullhorn:

"I am here to make a citizen's arrest of the Board of Governors of the Federal Reserve. We want our money back!"

I would pay $12.50 to see that.

© 2009 The Epicurean Dealmaker. All rights reserved.

Notes from a Presidential Address I Would Like to Hear

As delivered from the bully pulpit long ago, in another time and place, which looks a lot like this time and place:

Probably the greatest harm done by vast wealth is the harm that we of moderate means do ourselves when we let the vices of envy and hatred enter deep into our own natures. But there is another harm; and it is evident that we should try to do away with that. The great corporations which we have grown to speak of rather loosely as trusts are the creatures of the State, and the State not only has the right to control them, but it is duty bound to control them wherever the need of such control is shown.

— Speech at Providence, Rhode Island (August 1902)

Every man holds his property subject to the general right of the community to regulate its use to whatever degree the public welfare may require it.

— The New Nationalism (August 1910)

Our aim is not to do away with corporations; on the contrary, these big aggregations are an inevitable development of modern industrialism, and the effort to destroy them would be futile unless accomplished in ways that would work the utmost mischief to the entire body politic. We can do nothing of good in the way of regulating and supervising these corporations until we fix clearly in our minds that we are not attacking the corporations, but endeavoring to do away with any evil in them. We are not hostile to them; we are merely determined that they shall be so handled as to subserve the public good. We draw the line against misconduct, not against wealth.

— State of the Union address (December 1902)

* * *

There is more:

We stand equally against government by a plutocracy and government by a mob. There is something to be said for government by a great aristocracy which has furnished leaders to the nation in peace and war for generations; even a democrat like myself must admit this. But there is absolutely nothing to be said for government by a plutocracy, for government by men very powerful in certain lines and gifted with "the money touch," but with ideals which in their essence are merely those of so many glorified pawnbrokers.

— Letter to Sir Edward Grey (September 1913)

Political parties exist to secure responsible government and to execute the will of the people. From these great tasks both of the old parties have turned aside. Instead of instruments to promote the general welfare they have become the tools of corrupt interests, which use them impartially to serve their selfish purposes. Behind the ostensible government sits enthroned an invisible government owing no allegiance and acknowledging no responsibility to the people. To destroy this invisible government, to dissolve the unholy alliance between corrupt business and corrupt politics, is the first task of the statesmanship of the day.

— "The Progressive Covenant With The People" speech (August 1912)

* * *

Where oh where is the Bull Moose for our time and place?

© 2009 The Epicurean Dealmaker. All rights reserved.

Veterans' Day

November 11, 2009:

What passing-bells for these who die as cattle?
—Only the monstrous anger of the guns.
Only the stuttering rifles' rapid rattle
Can patter out their hasty orisons.
No mockeries now for them; no prayers nor bells,
Nor any voice of mourning save the choirs,—
The shrill, demented choirs of wailing shells;
And bugles calling for them from sad shires.

What candles may be held to speed them all?
Not in the hands of boys, but in their eyes
Shall shine the holy glimmers of goodbyes.
The pallor of girls' brows shall be their pall;
Their flowers the tenderness of patient minds,
And each slow dusk a drawing-down of blinds.

— Wilfred Owen, Anthem for Doomed Youth

Let us not forget those who have truly paid the price for our folly and our hate.

Nostra culpa, nostra culpa, nostra maxima culpa.

Photo credit: Great War Primary Document Archive: Photos of the Great War.

© 2009 The Epicurean Dealmaker. All rights reserved.

Character Study

Alfred Pennyworth: "A long time ago, I was in Burma. My friends and I were working for the local government. They were trying to buy the loyalty of tribal leaders by bribing them with precious stones. But their caravans were being raided in a forest north of Rangoon by a bandit. So we went looking for the stones. But in six months, we never found anyone who traded with him. One day I saw a child playing with a ruby the size of a tangerine. The bandit had been throwing them away."
Bruce Wayne: "Then why steal them?"
Alfred Pennyworth: "Because he thought it was good sport. Because some men aren't looking for anything logical, like money. They can't be bought, bullied, reasoned or negotiated with. Some men just want to watch the world burn."

— The Dark Knight

I have argued elsewhere at length that the bulk of commentators and regulators confronting the Panic of 2008 and its aftermath put far too much emphasis on the supposed causal effect misaligned compensation incentives had on these events. While these no doubt added to the problem in some instances, for the most part the focus on banker pay is poorly judged. Some of this error can be laid at the foot of natural envy, but some of it can be attributed to a fundamental misreading and simplification of the investment banker's character.

People continue to be excessively worried about investment bankers who are greedy, grasping, and covetous. Bankers who think of nothing but money. Bankers who are just like Joe and Ethel Sixpack, only richer, more ruthless, and less constrained by conscience.

But these are not the bankers we need to worry about. These bankers—who, make no mistake, do indeed exist—can be bought. If we cannot chase them out of too-big-to-fail banks where they make stupid or greedy decisions that harm our society and economy, we can encourage them to repay our bailouts to get out from under our yoke. These bankers are easy. We understand their greed and motivation, because it is essentially logical, and most of us share the same motivation to some degree, if only in paler, more attenuated form. These bankers are no challenge whatsoever.

But anyone who has spent real time in the trenches of investment banking knows that this description does not come close to exhausting the character of its practitioners. There are people in the industry who, when you get right down to it, have no real interest in money. People who couldn't give a flying fuck in a rolling donut whether they make $3 million, or $10 million, or $100 million a year, as long as they make more than the next guy. People who look at income, and bonuses, and aggregate net worth as a scorecard in the great game of life. People who want to make the most.

Or, those rare birds who do the business because they love it, because it's there, and because they can. People like a mentor I used to have who never should have worked a day in his adult life, according to any normal person's calculus. Someone who married into vast wealth, but who spent thirty years in sweltering Boardrooms, shitty motel rooms, and executive committee meetings which would make a dockside knife fight in Calcutta look like afternoon tea with the Queen of England because he loved the work.

Finally, do not forget the psychopaths.

Do you really think some bureaucrat's compensation limits are going to effectively constrain such people? Do you really think they will care? (I grant you, most of their wives will care. But that is what mistresses and prenups are for.) They will bitch and complain, but at the end of the day they will commiserate with compatriots over a 20-year single malt and a Cuban cigar and say "Fuck it." After all, most of these veterans were happy making 50%, 60%, or even 70% less money doing the same damn thing twenty years ago before Alan Greenspan turned on the liquidity spigot.

At best, Kenneth Feinberg's compensation rules for the seven TARP firms and the Fed's proposed guidelines on pay for the entire industry might chase out the opportunistic rabble who poured into the industry over the last decade to take advantage of its well-advertised pay and growing social prestige. People who, in other times, would and have flocked to law, or medicine, or technology startups and who, like rats off a sinking ship, will swarm onto another platform as soon as Michael Porter, or Seth Godin, or Sergey Brin identifies it for them.

Goddamn sheep. Extraordinarily well paid, well-dressed, and well-coiffed sheep, but sheep nonetheless.

Good riddance to them, I say. Let them go "add value" to some other poor misbegotten segment of society. Just watch your wallet when they show up on your doorstep.

* * *
But once these johhny-come-latelies leave, who will remain? I'll tell you who: people against whom your pitiful, transparent little compensation levers will have no effect whatsoever. People who do the business because they love it, because they are good at it, and because there are only so many slots open in the natural ecosystem for pinnacle predators, and the Great White Sharks and Polar Bears got most of them first.

People who will work with their counterparts in law, accounting, taxation, and Corporate America to extend the edge of the envelope and push the legal and regulatory barriers as far as they can go, because that is what they are paid to do and because they can. Because they are smart enough, and driven enough, and because they love the game. Because they take pride in their work. Just like any goddamn pipefitter.

These people are dangerous because they are smarter than you, because they are smarter than any regulator likely to be sent to control them, and because they hold in their hands the map and the controls to the vast and intricate system of pipes and valves which undergirds the global economy. Give them any reasonable set of legal and regulatory constraints—more stringent than the recent past, by all means, I implore you—and they will happily adapt and innovate around them in the future. Push them, and box them in, and reinstate Glass-Steagall if you must: they will grumble, but they will get over it.

But can you imagine what would happen if you pressed them too far? If you tried to turn the entire financial industry into a bunch of unionized, rule-bound clerks? These are personalities who do not go gentle into that good night. All you would need would be for one or two of them to decide they would rather watch the world burn than crawl into a hole.

And believe you me, you do not have enough water to put out that fire.

Not that I'm making threats, or anything. I am a reasonable man.

© 2009 The Epicurean Dealmaker. All rights reserved.

Shock and Awe

What the hell did I ever do to piss Steve Randy Waldman off?

I tell you honestly, Dear Readers, my afternoon conversation with this genial and intelligent gentleman started unremarkably enough, with a little playful banter in the Twitterverse on this and that. (I called myself a squirrel; he revealed himself to be a slime mold.) But then, something went horribly wrong. After trying to out me with an hurtful photograph of me wearing a hat I haven't owned in years (and an extra 20 pounds I have subsequently shed), he upped his attack on Your Peaceable and Equable Correspondent by trying to pick a fight between yours truly and the fearsome Economics of Contempt.

Now, I have to tell you I consider this very bad form. For one thing, my physical constitution and pugilistic skills are far better suited to being the spotty faced provocateur shouting "Fight! Fight!" from the perimeter of an altercation than being one of the principals. For another, I make it a practice never to get into a fight with a lawyer, unless I can attack him unexpectedly from behind with a lead pipe, preferably in the dark. Furthermore, my unwelcome opponent in this imposed brouhaha was none other than a structured finance lawyer, which every six year old knows is the most dangerous specimen of that deadly species. Heck, I work with structured finance lawyers all the time, which is why I count my fingers every time I shake one's hand and go through six liters a month of hand sanitizer.

So, suffice it to say I clicked through Mr. Waldman's incendiary link to EoC's post with a maximum of trepidation, calculating in advance just how many Russian hookers I might have to ply my opponent with to elicit mercy. But when I arrived, I breathed a virtual sigh of relief, for I discerned my opposite was far less formidable than I feared.


* * *
For one thing, Mr. Contempt's main purpose seems to have been to tie hedge fund principal and commentator Janet Tavakoli to a post and whip her decisively with a wet noodle. This he accomplished admirably, and I have nothing to add to the central thrust of his argument; namely, that Ms Tavakoli overstated her case and overplayed her hand. I also have nothing to add to his speculation on the exact size and nature of Goldman Sach's exposure to AIG in the troubled days of last Fall because, frankly, who the fuck cares?

However, I did note that Mr. C and I do in fact have a basic disagreement about the relative negotiating power at that time of Goldman Sachs and the other AIG counterparties, on the one hand, and the Federal government as owner of AIG, on the other. This, I think, is the core of his argument:

[T]here's no way Goldman would ever have agreed to a "bankruptcy-like settlement" — why would they? As someone who has actually been involved in these kinds of negotiations, let me explain how the AIG/Goldman negotiations would have played out:

AIG: Would you be willing to accept, say, 70 cents on the dollar?
Goldman: No.

THE END

Seriously, what could AIG have threatened Goldman with? If they didn't accept a haircut, AIG would file for bankruptcy? Fine, Goldman would've just seized the $7.5 billion in cash collateral, and collected the remaining $2.5 billion from its counterparties on the now-triggered CDS on AIG (on which more below), covering Goldman's full bilateral exposure to AIG. That's what it means to be "hedged."

(This is also why the Fed paid Goldman and the other counterparties 100 cents on the dollar to terminate their CDS contracts with AIG, which this Bloomberg article portrays as some sort of gift to the banks. But the Bloomberg article also relies on the Immaculate Negotiation argument — how, exactly, was the Fed supposed to get the counterparties to agree to take a haircut? The Fed had just demonstrated to the entire world that it wasn't willing to let AIG file for Chapter 11. How do you suppose those negotiations would have gone? The Fed couldn't say, "You can either take a haircut to 70 cents or AIG will file for bankruptcy and you'll only get 50 cents," because everyone knew the Fed wasn't willing to put AIG in bankruptcy.)

He then finesses Tavakoli's argument that Goldman wasn't adequately hedged in such circumstances because AIG's collapse would have engendered widespread systemic disruption and called into question not only the capability of any counterparty to satisfy its obligations under a hedge but also the health and solvency of every participant in the financial system. He does this by saying: 1) Oh yes they could, because the hedges were adequately collateralized, and 2) the potential for total systemic meltdown wasn't the scenario Goldman's CFO was talking about when he said they were adequately hedged. While neatly parrying Ms Tavakoli's principal charge that Goldman lied about its exposure, you must see that this argument almost entirely begs the question.

Mr. C also disagrees that Goldman—and, presumably by extension, the other counterparties to AIG's CDSs—faced any reputational pressure in these negotiations. He writes:

Finally, Tavakoli argues that Goldman's exposure to AIG included "reputation risk." Yes, I'm sure that if AIG had failed, Goldman's reputation for having prudently managed its counterparty risk would've been devastating.

While comprising an admirable example of sarcastic snark, this remark completely mischaracterizes the circumstances surrounding AIG's near death experience last year. All one need do is read a few pages in Andrew Ross Sorkin's hour-by-hour account of the collapse of Lehman Brothers and its aftermath to realize that "reputation risk" encompassed far more than each individual firm's performance of its fiduciary duties alone. More to the point, the CEOs and Boards of the principals involved were very well aware that business—or fiduciary duty, or contract law, or corporate governance—as usual was completely and utterly out the window:

On the surface, Goldman looked like one of AIG's biggest counterparties, but earlier that morning, Goldman's Gary Cohn had boasted internally that the firm had hedged so much of its exposure to AIG that it might actually make $50 million if the company collapsed. The firm's decision to buy insurance in the form of credit default swaps against AIG beginning in late 2007 was starting to seem like a smart investment. The firm had conducted what it internally called a "WOW analysis"—a worst-of-the-worst case scenario—and it was quickly coming true. Even though Goldman had hedged its direct exposure to AIG, [Lloyd] Blankfein appreciated the larger problem: The collateral damage to its other counterparties and the rest of the market could expose the firm to untold billions in crippling losses.¹ [emphasis mine]

So, let us not be legalistic, or simplistic, or disingenuous here. Under normal circumstances, I would completely agree with my professional better and, indeed, would and have paid him and his kind mucho dinero to advise me on the way structured finance does and should work when all is right with the world. But virtually nothing was right with the world in the fourth quarter of 2008. Cats laid down with dogs, Paris Hilton matriculated at Oxford, and the thundering hoofbeats of the Four Horsemen could be heard in broad daylight throughout the canyons of Wall Street. The system was on the knife's edge of chaos, and everyone with half a brain—including Goldman Sachs and all of AIG's other counterparties—was very well aware of that.


* * *
So, in the spirit of Mr. Contempt's entertaining post, I would like to propose an alternate transcript for what I think might have occurred during those dark days had I or one of my professional counterparts been in charge of negotiations with Goldman Sachs et al. Normally, I would not reveal a potential negotiating strategy such as this in public without an enormous and frankly obscene fee already marinating nicely in my personal bank vault, but I am feeling inexplicably charitable. Also, it is clear from the underwhelming response to my previous offer of assistance that the Federal government has the backbone and intestinal fortitude of an earthworm, so I'm not worried I am giving away potentially lucrative advice to a client who might actually hire me.

Anyway, let's proceed:

TED, as representative of the Federal government and AIG: Welcome, gentlemen. Please take a seat, and let's begin.

Senior representatives of Goldman Sachs, SocGen, BAML, et al., as counterparties to AIG: Thank you.

TED: Now, you all realize we are here to resolve the payments which the government of the United States of America, as majority and controlling owner of AIG, proposes to make to each of you to cancel the credit default swaps from AIG you each hold. Before we begin, I would like to make a few opening remarks.

Counterparties: Uh, okay.

TED: First, let me remind you that we are here—and the federal government is here—because our country and indeed the entire world stands upon a knife's edge. We took control and injected tens of billions of dollars of taxpayer money into AIG because we did not want to see this company collapse in an uncontrolled fashion. We believed then, and still believe, that such a collapse would threaten the entire global financial system and indeed the entire global economy. I do not need to explain to you gentlemen the effect such a collapse would have upon each of you, your firms, your employees, and your capital providers. I do not need to explain to you the effect such a collapse would have upon our society, our political system, and indeed the very social order upon which we depend to live our daily lives. We in the government do not have a crystal ball in this regard, but I have been authorized from the very highest level to convey to you that we are scared shitless. You should be too.

Counterparties: [Uncomfortable silence; shifting in seats; coughs]

TED: I have also been authorized to inform you that we are fully aware of the legal rights and fiduciary duties which constrain each of you to do what you think is best for your firms and your stakeholders. Under normal circumstances, we would be entirely supportive of these obligations. However, these are not normal times. Furthermore, and because these are not normal times, I would like to inform you that the government of the United States of America will take an extremely dim view of any individual or institution which chooses to pursue simply its own interest and its own duties without regard for the consequences to the broad economy, this country, and indeed the entire world. This government has a fiduciary duty too, gentlemen, and I am afraid that it trumps yours.

Counterparties: [Angry murmurs, outbursts, shock and outrage, etc.]

TED: Gentlemen, gentlemen, please. Let me continue. I am not finished.

Now, this discussion is a voluntary one. None of you have been compelled to attend this meeting, nor indeed can be compelled to give your acquiescence to what we intend to propose. Some of you here represent companies which are headquartered in foreign countries, and which derive their corporate authority and obligations from the laws of other lands. Be aware that the United States government has already discussed the settlements we will propose here today with ranking representatives of your countries' governments, and we have received their approval and acquiescence.

We previously requested that all of you arrange whatever entities you may need to authorize the corporate and board level approvals your bylaws may require to be standing by, so there is no further delay in resolving these critical issues. The decision point is now, gentlemen. It is today. It is in this very room. The government of the United States of America will brook no further delay.

Counterparties: [Wilting, sweating, uncomfortable silences]

TED: And before we get to brass tacks, gentlemen, allow me to make a personal observation. I have known and admired many of you for many years, and I personally respect the power and dignity of each of your individual institutions.

But I am not your friend today. I am not your fucking friend. As far as you are concerned, you should view me as the Angel of Fucking Death. Because the time has come for each of you to do what is right for the greater good. It is time to think about survival, gentlemen—your own and that of your institutions—both now and in the future. For let me assure you that the decisions you make in this room today will be remembered. They will be remembered, gentlemen, as long as there is a United States of America. And if, God willing, we all come through this terrible crisis to a safer and more stable world, those people who helped us get there will be remembered. And, perhaps more importantly, those people and institutions in this room which did not help us, which put their own narrow personal and corporate interests before the interests of this nation and its people, will be remembered as well.

And let me tell you something, gentlemen, banker to banker: you do not want to be on that list. That list will be a world of pain. That list will be Death. That list will be populated with people and institutions which will have the full weight, power, and authority of the government of the United States of America brought down on them in the most thorough, comprehensive, and legal way you could possibly imagine. That list will be the proctology exam from Hell, and it will never end.

So, having set the stage, you should each find before you a term sheet with a proposed haircut for the AIG CDSs your institution currently holds. In each case, this is the government's best and final offer. I would like each of you to retire from this room with your team, talk it over amongst yourselves and with your Board, and bring the signed term sheets indicating your firm's acceptance of these terms back to me in this room. You have one hour.

Any questions? No?

Then I thank you for your attention. You may leave.

* * *
Would this approach have recovered all 40% of the original discount AIG tried to obtain? Probably not. Tough talk or no, the assembled banks would balk at completely unreasonable demands by the government. And if they balked, they would have time to mobilize their vast lobbying apparatus to try to counteract the government's bid through Congress. Delay would be deadly. You could not allow the counterparties to regroup, or even collect their thoughts.

You've gotta drop a daisy cutter on their ass, and roll the tanks in immediately thereafter. Shock and awe, baby.

But you know why this could work? Because all those bank CEOs and CFOs would look across the table at me and realize: this guy is a mercenary, heartless, psychopathic bastard just like me. And he is getting paid to run a Roto Rooter up my ass. Let's get it over with, and then I can plan my revenge on this bastard later on.

I'm an equal opportunity asshole, baby. I'll screw anyone over. Investment banks can deal with that.

¹ Andrew Ross Sorkin, Too Big to Fail. New York: The Viking Press, 2009, p. 383.

© 2009 The Epicurean Dealmaker. All rights reserved.

Never Send a Boy to Do a Man's Job

Interesting article over at Bloomberg.com this morning. Did you see it?

Oct. 27 (Bloomberg) — In the months leading up to the September 2008 collapse of giant insurer American International Group Inc., Elias Habayeb and his colleagues worked nights and weekends negotiating with banks that had bought $62 billion of credit-default swaps from AIG, according to a person who has worked with Habayeb.

Habayeb, 37, was chief financial officer for the AIG division that oversaw AIG Financial Products, the unit that had sold the swaps to the banks. One of his goals was to persuade the banks to accept discounts of as much as 40 cents on the dollar, according to people familiar with the matter.

Among AIG’s bank counterparties were New York-based Goldman Sachs Group Inc. and Merrill Lynch & Co., Paris-based Societe Generale SA and Frankfurt-based Deutsche Bank AG.

By Sept. 16, 2008, AIG, once the world’s largest insurer, was running out of cash, and the U.S. government stepped in with a rescue plan. The Federal Reserve Bank of New York, the regional Fed office with special responsibility for Wall Street, opened an $85 billion credit line for New York-based AIG. That bought it 77.9 percent of AIG and effective control of the insurer.

...

Beginning late in the week of Nov. 3, the New York Fed, led by President Timothy Geithner, took over negotiations with the banks from AIG, together with the Treasury Department and Chairman Ben S. Bernanke’s Federal Reserve. Geithner’s team circulated a draft term sheet outlining how the New York Fed wanted to deal with the swaps—insurance-like contracts that backed soured collateralized-debt obligations.

...

Part of a sentence in the document was crossed out. It contained a blank space that was intended to show the amount of the haircut the banks would take, according to people who saw the term sheet. After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public.

Uh, okay.

* * *
I must admit, Dear and Long-suffering Readers, that my first reaction to this news was of a kind with several of the sources quoted in the article: white-hot, scalding rage.

I mean, what the fuck?! Tim Geithner and pals left up to thirteen billion dollars of taxpayer money just sitting on the table? Why?

[B]ecause some counterparties insisted on being paid in full and the New York Fed did not want to negotiate separate deals, says a person close to the transaction.

Oh, that's a good reason. No, really, I mean it.

Dumb fucking cocksuckers.

* * *
Now, to be fair, I am not willing to swallow the Bloomberg article hook, line, and sinker. For one thing, none of the numbers I have been able to glean either from it or from other sources add up. I suspect the high-speed, real-time negotiations over cancelation of the credit default swaps, purchase of the "super-senior" CDOs underlying AIG's CDSs, and coincident payment by AIG of increasingly frequent, strident, and large collateral calls by its counterparties during the frantic days of mid-September a year ago make it damn difficult for anyone to reconstruct exactly what happened and who paid how much to whom and when, much less a bunch of underpaid, slightly innumerate financial reporters.

And you definitely need to read between the lines. Just because Elias Habayeb intended to persuade Goldman Sachs, SocGen, Merrill Lynch, Deutsche Bank, and several other representatives of The Great Deceiver Here on Earth to accept 40% haircuts doesn't mean he had a snowball's chance in hell of doing so. In fact, the GAO's September 2009 report on the AIG fiasco unequivocally states his efforts failed prior to the government takeover (p. 17):

AIG’s negotiations with counterparties and creditors to reduce the outstanding obligations through contract renegotiation had proven unsuccessful.

But this selfsame GAO report clearly outlines the issue with the Fed's subsequent precipitate actions (p. 18):

Critics of the government’s assistance have noted that by providing assistance to AIG for the purpose of providing or returning cash collateral to counterparties, the government was indirectly assisting the counterparties, and they questioned the efficiency of this approach. Some noted that banks that had bought CDS contracts from other failed insurers were paid 13 cents on the dollar in deals mediated by New York’s insurance regulator, whereas AIG’s counterparties were paid market value. They said that new capital to AIG in effect served as direct infusions to the counterparties, including foreign financial institutions. Conversely, Federal Reserve officials believed that if AIG had failed to pay the collateral amounts due, it would have been in default of its agreements, which could have resulted in AIG’s counterparties forcing it into bankruptcy. Moreover, they believed that the unfolding crisis warranted swift action to prevent total collapse of the financial system given its fragile state at that time.

It is clear that some banks were in deep doo-doo as AIG spiraled ever more quickly toward its predestinate sticky end (p. 22):

Finally, the Federal Reserve and Treasury stated in separate reports and testimonies in the fall of 2008 and early 2009 that the failure of AIGFP could have led to billions of dollars of losses at bank counterparties that bought CDS contracts from AIG.²⁹ Because many banks used these contracts as credit protection, following losses to CDS contract holders, if any, AIG’s failure could have led to mounting losses through sudden, unhedged, uncollateralized exposure as market conditions worsened and underlying assets continued to decline in value. Banks and other counterparties could have faced declining capital bases because of these unrealized losses. Moreover, counterparties with unfulfilled derivative contracts could have faced difficulties in offsetting balance sheet exposures through replacement derivatives, and they would have had to confront the possibility of entering into new contracts at a time when market participants had become increasingly risk averse and unwilling to execute new transactions.

Of course, not all of AIG's counterparties would have faced wrack and ruin had it defaulted on its obligations. Most notably, Goldman Sachs crowed loud and long at the time that it was fully hedged against AIG's untimely demise, and that it couldn't give a rat's ass whether Bob Willumstad's company took the pipe or not. This has led more than one market observer to speculate that the $11 or $12 or $13 billion in cash which the Federal Reserve presented to Goldman on a silver platter represented a particularly fetching and unexpected gift from the pockets of the American taxpayer direct to the bank accounts of Goldman's employees. It certainly encourages me to believe that whatever difference between a realistic haircut Goldman could have expected to endure on AIG's CDSs and the no-haircut they did receive represents a particularly large and tasty helping of frosting on an already delicious and unexpectedly rich cake.

Taking, for argument's sake, the 40% figure bandied about, that would be about five billion dollars worth of buttercream for Lloyd and his buddies. Or, as a point of reference, a figure approximately equal to the entire compensation and benefit expense Goldman recorded in its most recent fiscal quarter. Sweet, huh?

* * *
So, what's my point?

Just this: Tim Geithner and the Federal Reserve got royally played. And you and I, my friends, paid dearly for the privilege.

Sure, the Fed was worried that AIG's uncontrolled collapse could lead to a complete and utter meltdown of the global financial system. Even now, with the worst of the crisis behind us and plenty of time to reflect, it is hard to criticize this worry as hysterical. It is also true that things were moving way too quickly to sit down and think them through logically, so we should not superimpose unreasonable expectations of measured, rational thought on the Fed's negotiators. It is also even remotely possible that some of AIG's counterparties were so inept and unprepared for the insurance company's troubles that they truly might have blown up themselves if it went down. (Although AIG's train wreck was so long coming and so well telegraphed that any bank so blind to the obvious and unprepared for the inevitable probably should have been shut down purely on principle.)

But Christ, people, think about it.

What moronic financial entity—fully hedged or not—would really risk global financial catastrophe by throwing AIG into bankruptcy, even if it had the contractual and legal right to do so? Because it insisted on receiving 100% of the proceeds due to it by contract? Even though parties to financial contracts renegotiate existing terms under normal market conditions all the time? What good, for example, would those extra five billion clams—not collected, by the way, until the bankruptcy judge wound the company down, if ever—have done Goldman Sachs if it, Morgan Stanley, and every other major investment and commercial bank were in liquidation too?

Furthermore, what foreign or domestic bank CEO in his right mind has the balls to threaten the government of the United States of America with financial meltdown if it doesn't cough up another couple billion dollars out of the public purse? Are you fucking kidding me?

AIG's counterparties had no leverage whatsoever. None.

Of course, Geithner and Bernanke were over a barrel, too, because they didn't want to do anything stupid to trigger Armageddon either. Among other things, I believe it is in their brief to prevent just such annoyances. I do not claim they should have been able to get all 40% of the target discount from the banks. But nothing? Not even from the guys who claimed not to care?

Give me a break.

* * *
Now, I am sure I will catch flak from the usual suspects—ignorant twenty-somethings who have never renegotiated a contract in their lives and disingenuous ideologues who have and should know better—for suggesting it, but I think the Fed has a good case for clawing back some of AIG's payments. I think a couple of quiet words with the CEOs and Boards of Goldman Sachs, SocGen, BofA, and Deutsche Bank could go a long way toward encouraging a "voluntary" return of some of these monies to the public purse. Consider it, if you will, a generous donation from the assembled titans of finance for the benefit of the regulators who pulled their testicles out of the fire a mere thirteen months ago. A grateful gift, so to speak, from the money men to the people and officials who make their very existence possible.

Of course, history and common sense tell us that a mere bureaucrat will lack the credibility to deliver such a threat message to the Masters of the Universe. Even now, as Secretary of the Treasury, Mr. Geithner is more likely to inspire giggles of disbelief from Lloyd Blankfein et al. than deferential respect.

No, what you need is a professional psychopath, a highly trained and expert negotiator, who will tuck his Hermes tie into his shirt and slap the offending CEOs silly before emptying their firms' bank accounts. Someone who can run roughshod over the rights and expectations of self-interested plutocrats in the name of Life, Liberty, and the Pursuit of Happiness, or at least a balanced budget. Someone who can make assembled onlookers squeal in horror as he tramples precedent, custom, and noblesse oblige into the mud alongside all the other tired, self-righteous pablum capitalists and free marketeers have been reciting like Holy Writ for nigh on thirty years.

Someone who isn't afraid to negotiate hard. Someone who isn't afraid to scream, and yell, and threaten all sorts of horrible consequences, real and imagined, for anyone who doesn't accede to his demands.

And, since Steve Rattner is no longer in the picture, I guess it'll just have to be me.

Lloyd, you are so fucked.

© 2009 The Epicurean Dealmaker. All rights reserved.