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Wednesday, November 04, 2009

A Sit Down With Senior Treasury Officials - Part I

I received a mysterious email last week from the Treasury, inviting me to a discussion about the Administration's policies and reactions to the economic crisis.  Although the timing sucked for me - it was the Monday following the weekend of my move out of NYC - it was too rare an opportunity to pass up.

Arriving at the Treasury, I quickly bumped into AccruedInterest along with John Jansen from Across the Curve.   Michael Panzner soon joined us, before we were escorted to the proper conference room, where we found Yves Smith from Naked Capitalism, Steve Waldman of Interfluidity, Tyler Cowen from Marginal Revolution, and David Merkel of Aleph Blog fame.  In all, there were 8 "bloggers" and a handful of senior Treasury officials, who shall remain nameless.  Henceforth, all Treasury views will be attributed to "STO" - Senior Treasury Officials.

STO began the session with a little background regarding the Administration's response to the financial crisis.  The first point that caught my ear was the description of the stress tests as having been designed to restore a level of confidence in the banking system.   The STO mentioned that the focus was now on reducing the footprint of economic intervention cautiously, quickly and prudently.    Michael Panzner jumped right in, addressing a concept I've writted about previously - that of "extend and pretend," or "delay and pray" - the concept of attempting to avoid recognizing actual losses and or insolvencies, and growing out of them after enough time.  Panzner called it "fake it 'till you make it."    I mentioned that I felt like we were undergoing a "Ponzi scheme of confidence" - but that confidence mattered less than ever in the current environment where, contrary to perhaps the prior 10 years, confidence can no longer be "spent."

In other words, 5 years ago, the economy could be kept churning along if consumers were convinced that things were going to be ok - they could go and borrow more and spend more.  They could take out another mortgage on their home.  Today, on the other hand, that credit bubble has popped - we're broke, both as a consumer, and a nation - and we can no longer simply "spend" confidence by levering up our personal balance sheets any more.    I challenged the STO that he had a poor choice of words in describing the stress tests as designed to restore a level of confidence, rather than to determine which banks were healthy and which were insolvent.

This drew a chorus of "whoa whoa's" and a murmur from a number of STO's present in the room, who quickly banded together to clarify that no one knew the results of the stress tests before they happened, and that they were designed to restore confidence by identifying the levels of capital needed by the banks, and requiring them to raise such capital.  I said that if they wanted to restore confidence, they should require banks to mark assets to market, and depict the true financial situation.

The response was that banks don't mark to market because, well, that's just not what they do - since they hold assets to maturity.  It was also pointed out that if banks had been required to mark to market, the system would have been insolvent multiple times in the past 50 years.  I almost laughed - that was my whole point - just because you pretend that the system is not insolvent doesn't mean that it's not insolvent!  Holding assets to maturity does not mean you'll receive your principal back, obviously.  I also noted that I understood that my background in equities gave me a slightly different perspective, since our (equity) assets were much more liquid and had to be marked to market daily - but I took umbrage with the recent decision by the FDIC to allow banks to recognize commercial real estate loans which were clearly impaired as "performing" and avoid taking writedowns.  I referenced David Einhorn, who wrote an entire book on Allied Capital - whose accounting shenanigans attempted to hide the health of their loan book in exactly this manner.  Loans which were certain to default, but had not yet defaulted were still recorded on the books at full price, and as "performing."

I failed to draw an analogy to the local Washington Redskins, which I think would have been a good one:  the Redskins are technically in the NFC East playoff race - they haven't been mathematically eliminated yet - but in reality, they are not a contender.  Similarly, many of these CRE loans are technically "performing" - the payments are currently being made - but the values of the properties are down massively, rents are falling,  and it's widely recognized as a mere matter of time before the loans default in one form or another.

David Merkel jumped in with the suggestion that even if loans are not marked to market prices, there still has to be an increase in capital requirements held against loans that have seen their market values impaired.

Steve Waldman was a harsh critic of the policy of "Prompt Corrective Action," and was credited (by me) with the quote of the day when he addressed one STO on the regulatory reform plan: "I've read your bill, and it's terrible - no offense," and followed with "too big to fail is too stupid a criteria."    This led to a discussion of how capital ratios were not the problem - although I do think they are a part of the problem.  The buzzword issue was really "interconnectedness," aka, "counterparty risk."

There had been suggestions as far back as a year ago, I believe, about having a central counterparty risk identifier, like the Federal Reserve, monitor the net counterparty risk of each firm, and quantify it systematically.  I mentioned that the problem was that even if we had a "Counterparty Risk Czar" who somehow managed to magically quantify the exposures of each firm (which may be quite a difficult task in itself), we'd see the same problems we saw when the government went to give out the TARP funds. The government didn't want to "bail out" select firms (ie, BAC and CITI) because they feared that the stigma attached to such assistance would create panic and runs on the bank - so they asked a large pool of financial institutions to take the money to hide the truly sick cows.  The Counterparty Risk Czar would have the same issue - if he were to somehow miraculously identify that Firm A had too much exposure to Firm B, the very announcement of such extreme exposure would become a self fulfilling prophecy and result in panic by investors in Firm B, which would in turn spread like wildfire to Firm A.  Is the solution to move the trading of every product onto a clearing house centered exchange?  Perhaps, although that would eliminate an immeasurable amount of OTC trading that the system seems to need to keep churning at its current size, and hamper the economic growth fueled by it (with "it" being financial engineering, in some sense).

I made another point that, although I was not going to presume to lecture a room full of economists and pseudo-economists (as one STO described himself) on economic theory, it was clear to me that they needed to throw away their old economic playbooks.  The thing that bothers me most about economic history is that it's based on a relatively small number of samples.  Furthermore, the inputs in each scenario are vastly different.  Today, for example, we have record length of time the government will provide unemployment benefits, record length of time people spend receiving unemployment benefits, and yet still a record number of people exhausting unemployment benefits.  I cautioned the economists in the room that there is no rule about what "usually" happens when GDP rebounds from -3% to +3% - or when unemployment goes from 5% to 10% - because it's the INPUTS that determine the rationale for the response.  In other words, a +3% GDP print from government spending (which I maintain is what we just saw) is very different from a +3% GDP print from organic economic growth.  The stimulus induced GDP growth will revert when the stimulus stops.

Stay tuned for Part II - where I"ll talk about some unsatisfying answers to questions asked by myself and others, and attempt to synthesize my interpretation of the Treasury's stance on policies.

-KD 

23 comments:

Joel said...

Good stuff, can't wait for part II... I'm assuming that's when you all are appointed to some new board to help get us out of this mess...

bergsten said...

Did the Feds pay for the trip?

Frank said...

how many bloggers id DON'T correspond to their gender? good bit, btw

bergsten said...

Did the invitation cite a purpose/agenda for the meeting?

Carlo Ponzi said...

A dude with a blog about gambling gets invited to a confab with STOs. Makes perfect sense...

S said...

fascinated by your discussion of dark pools and algos - curious however when you boil it all down top info arb and spread how one can argue in favor? Clearly the banks running them are arbing the spread/impact differential of the exchange or there would be no need for them (in spite of the reported discovery after the fact). Putting aside technical jargan and execution arguments - because I banks arn't in the bsuiness of altruism - can you identify the arbitage? if it is an informational one how can one argue without the default "better execusion" reflex that it isnt scalping by another name

Kid Dynamite said...

bergsten - they didn't pay for it, although i asked. the pretense of the meeting was "As part of Treasury’s efforts to communicate with the public"....

Carlo - this is hardly a blog about gambling - although it once was...

S - i think you overestimate the arb - dark pools were created because customers needed/demanded them. Banks run them because they charge commission - it's like running their own little exchange - not because they arb the flow within them.

bergsten said...

"They didn't pay" -- sorry.
"Pretense of the meeting" -- good one!

getyourselfconnected said...

Hey,
I cannot believe I never came across your blog before. Great writing and a poker player! I really wish online poker would return, I rmemebr the good old partypoker sit-n-gos.

Thanks for the most interesting report from the Treasury meeting.

Mytgod said...

I can relate.

I was recently asked by local government officials to meet with them to discuss the penalties and payments incurred as a result of what is apparently the illegal activity of minding my own business outside of what I didn't know was the bathroom window of what turned out to be a high school girl from my neighborhood but how's a guy supposed to know where is and where isn't ok to mind one's own business and where do they get off assuming I was peeping on this busty young lady because there are many reasons I could have been standing there minding my own business and none of THEM were assumed and I can promise you each of those scenarios would explain why I had my pants around my ankles.

Don't worry, though. I think my "elastic bands lose effectiveness over time" defense will explain the pants.

I'll keep you posted.

Anonymous said...

Just a thought gents. Did you think that maybe they invited you to see if you've been able to pick up the scent of something they are hiding. You know something really nasty. Not the normal we've stolen trillions and there's nothing you can do about it. Something really bad.

s said...

it is my feable understanding that many of the qunts take the large basket trades break them into packets and run them through the pools. If so arn;t the pools merely a back end to the hft and front side. Regardless, seems the arb has clearly been measured and it would comprise the differential between what the potential price exchnage execusion is and what the pool costs plus commision. Indeed if the pool where not intact would not some of the churning be uneconomic? any studies on this?

Also as to last point what was the criteria for being selected - Yves, waldman and JJ and Accruedint were obviously thought to be persuadable

Kid Dynamite said...

S - yes - more liquidity certainly helps the "churning" as you call it, because more liquidity always helps. I guess you could say that the dark pools are a "back end" for HFT - but my point is that the HFT algo's cannot prey on the dark pool volume - they can USE the dark pools as another liquidity source, but cannot "pattern map" the dark pools - because there are no bids/offers to "pattern map"

as for the criteria - I don't know what it was - but i don't think the Treasury was successful in persuading this group that I was a part of.

David Chessik said...

Hello,

Accountability and responsibility go hand in hand, and accountability is personal accountability, there is no other kind. When they demanded your promise to not attribute what they said to them individually, why didn't you leave? Or tell them that is not possible. Selling out principles of freedom as a ticket to the 'in group' is not bright. Between governments and governed, truth must rule, not agreements to surpress the truth, and fail to hold government officials to their record. I love your blogsite, but I am concerned about agreeing to diminishment of freedom to win access. Tell em to shove it.

Kid Dynamite said...

Hi David - that's an interesting comment, and one that I'd generally tend to agree with, but i think it's a bit too idealistic. After all, whatever access I was able to get to the Treasury, and whatever responses I was able to absorb and re-communicate are doubtless better than the alternative of proving the ideological point of telling them to suck it, which would result in me getting zero access.

you call it a diminishment of freedom - i don't agree. Had I told the treasury "fuck you, Kid Dynamite will quote you or he will leave," they would have escorted me out, and you'd be staring at a post about me raking leaves in my new yard today (which is what i'm taking a break from right now!)

would that be better?

asphaltjesus said...

Question: looking back on the event, were there ideas/opinions *prior* to the meeting that changed *after* the meeting to make your opinion of the Treasury/Policy/Whatever more favorable?

I think that was the Treasury's goal. Why? Because it then becomes easier for them to influence the public discussion.

Whether you like it or not, the trip will affect your opinions going forward. You will probably give the Treasury a *little* more positive spin where maybe before the trip you would have come down harder on whatever issue you are writing about.

This is very common and well documented social/psychological phenomena irrespective of culture.

It doesn't mean you'll be the Treasury's new cheerleader. Perhaps a little more friendly to them in your writing?

Thanks for writing about the trip.

Anonymous said...

Kid,

Did you sign a contract about quotes and ID's, or was it just scout's honor? Hell, I'd do it anyway. It's not like they'd be able to put the cat back in the bag afterward.

Kid Dynamite said...

@Asphalt - i don't think so. if anything, I was more frustrated that my one key question was basically shafted (wait for part II)

anon - no - i didn't sign any disclosures. but i don't think it really detracts from the recap that you don't know the names of the people who were in the room.

getyourselfconnected said...

I am glad you did not just walk out. I do not think it is material to have to know which exact Treasury official said X,Y, or Z only that the Treasury was involved with the discussions. No issue there.

Thanks for the information and looking for Part II.

PS;
I am from Northeast Massachusetts near NH border and yes the leaves are rough, but the acorns this year are almost to the silly point.

David Chessik said...

You should not have walked out, but you should not have agreed to any supression of speech, especially before you knew who was going to say what. Why is the Gov't calling bloggers in for a talking to, in secret?. Really, you should not consider yourself bound by that kind of agreement, its not enforceable. By the way, did you insist that they submit to your demands on their future communication? You gave them credibility with your presence, they took your credibility by having you submit to their unreasonable demands. Next time they will demand more control over you. You don't give an inch on principles of freedom when dealing with corrupt men of appetite and greed.

Kid Dynamite said...

@David - i think if they demanded I write bright flowery things about the Treasury crisis response, that would be unreasonable. Similarly, if i wrote such flowery things with the hope of being invited back, THAT would be a compromise of my values, integrity, and credibility.

fortunately, that is not what happened.

camilynn said...

Very thoughtfull post on "A Sit Down With Senior Treasury Officials - Part I".And I would like to say that I'm living my dream of owning my own business and working from home earning equally or more than the regular jobs by using http://debtfreeliving.ownanewbusiness.com.

Thanks,
Peter- Own a new business

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