Robert Waldmann

A proposed reform (already shelved) is to require banks to offer "plain vanilla" products. I am very confused about this proposal, so this is a semi bleg. I can't see any possible benefit from the regulation (probably because I haven't read the fine print of the draft bill).

My thoughts after the jump.

Bottom line -- a vanilla option must include the rule that at least x% of a bank's business must be vanilla or they pay a fine to work.

Also, I propose calling non vanilla products "fudge swirl" products unless anyone has ever scene "fudge twist" or "fudge spin" ice cream.

update: Jump corrected so most of my post is after it.
Also see Waldman vs Waldmann after the jump.


I will criticize a proposal which might exist only in my imagination. A very silly vanilla rule that just says banks must offer a plain vanilla product -- say a 30 year fixed rate mortgage. [Here is an] explanation by [Steve Waldman at] Interfluidity via rortybomb:

Vanilla products would turn basic financial services into a commodity business, and force providers to compete on price…. Since vanilla financial products would be commodities, banks would have to universally collude to offer them at inflated prices in order to bilk consumers. Competing vanilla project offerings would (at least they should) vary only on a single dimension (e.g. an interest rate). Points, fees, penalties, etc. would be homogeneous or uniformly pegged to the core price.

This argument does not apply to a simple requirement that banks offer vanilla products. Forcing them to offer the product does not force them to compete to sell the product.

Consider the case in which all banks offer fixed interest 30 year mortgages at 100% interest per year. Technically they have fulfilled the silly vanilla requirement. There is no improvement in anything as offering a fixed rate mortgage at 100% is just like not offering a fixed rate mortgage.

So, in the absense of collusion, is this alleged equilibrium vulnerable to deviation by a firm which offers a reasonably priced fixed rate mortgage ? It might or might not be. If it isn't then the silly vanilla rule will not be effective. If it is, then the silly vanilla rule is not needed and will make no difference.

Since offering fixed rate mortgages at 100% is just like not offering them, the equilibrium profits and profits to deviators are just the same as in the case in which there are no vanilla products and one bank can deviate by introducing one.

If compliance with the regulation implies no real change at all, then a bad equilibrium with technical compliance will be identical to a bad equilibrium with no regulation, one is a Nash equilibrium if and only if the other is and payoffs to all agents are just the same.

So "forced to compete" only makes sense if the vanilla rule is not the silly vanilla rule. It makes sense if there is a requirement that say at least 10% of a bank's mortgage lending must be fixed rate 30 year. Then banks will compete to issue fixed rate mortgages even if they are not as profitable as option ARMs etc , because by loaning a dollar at a fixed rate for 30 years they win the valuable right to loan 9 dollars as option arms.

I have no idea if the proposed now shelved rule was the silly vanilla rule (hence the bleg)

Steve Waldman to me
show details 5:23 AM (15 hours ago)


Robert,

I tried to add this as a comment to your Angry Bear post, but alas, I am too logorrheic. The post was rejected, and I am too lazy to edit.

So I offer it to you, fwiw...

smiles,
Steve

---

Robert -- I hesitate to disagree with you, because you have that extra 'n' that gives you superpowers of which I can only dream.

But you are wrong, right here:

"Since offering fixed rate mortgages at 100% is just like not offering them, the equilibrium profits and profits to deviators are just the same as in the case in which there are no vanilla products and one bank can deviate by introducing one."

This would be true if consumers had perfect information and could distinguish safe from unsafe products, vanilla from fudge swirl. But in a world where all financial products that banks offer are opaque to most consumers, and where therefore consumers attach an uncertainty cost based primarily on offering institution, no bank has an incentive to deviate with a less profitable vanilla product. Suppose a 30-year "fudge swirl" mortgage creates higher revenues in expectation (and higher costs to consumers) than a 30-year vanilla. But consumers cannot distinguish fudge swirl from vanilla. Then offering only fudge swirl is the dominant strategy for banks. Offering vanilla involves fixed costs of product development, and consumers that choose vanilla are just an opportunity cost viz fudge swirl.

Now suppose a trusted external party, call it "the government" certifies some products as vanilla. (There is no other party that could credible on this given the incentives to game certifications, and even the government might be too compromised.) Now consumers can distinguish between vanilla and fudge swirl, and deviating involves benefits as well as costs. Offering a non-100% 30 yr vanilla will capture some extra consumers, who know it is that good clean flavor they like, leading to extra revenues, while it will also cannibalize some existing, more profitable nonvanilla prospects. Under this circumstance, there should be deviation, as the sole provider of vanilla (under reasonable assumptions) would gain much more by taking other firms' prospects than they'd lose downselling their own client base.

This argument suggests that there's no reason to require any bank to offer vanilla, just a requirement to have the government certify some products as vanilla. And I think that's mostly right, although I support a requirement for the sake of timing, because it can take a while for existing well-policed cartels to collapse despite a favorable Nash equilibrium. That is, if CFPA simply defined a schedule of vanilla financial products and offered to certify compliant offerings, the larger banks would "as a matter of principle" refuse to participate, and many smaller banks as well by virtue of industry/ABA pressure. The industry would also lobby for very elaborate certification requirements for vanilla products, and that banks should pay their own certification costs, to create a barriers that would help to discourage smaller deviators. Still, if the certification barriers aren't too outlandish, some small and midsize banks would deviate. Since financial product markets are segmented (there are many customers who for arguably misguidedly perceive larger providers as safer or more reliable), big banks wouldn't be under very much pressure to follow suit and compete. Eventually, again if certifiation costs aren't outlandish, the cartel would break, and fundamentally, mere credible certification of vanillahood would be sufficient over the long run. But over the long run we're dead. I support vanilla as a requirement because I want to see informationally-protected financial services rents collapse quickly, not "at equilibrium".

Note that the market that would be least affected by vanilla products is mortgages, because a de-facto vanilla standard already exists -- GSE requirements for prime mortgages. Here we can see that...

1) vanilla is not a panacea -- there has long existed a widely known vanilla product, yet banks often persuaded prime-eligible consumers to accept products with much higher expected costs by offering attractive features like teaser rates and negative amortizations. People can still choose belly-ache when vanilla is on offer, and they will.

2) vanilla is not useless. Many homebuyers, understanding that mortgages are a complex game they are ill-equipped to play, forgo lower down- and monthly payments to stick with "traditional prime" mortgages. Vanilla has worked exactly as it is supposed to for this population: homebuyers can shop around for a prime mortgage based on fees, perceived service, convenience, etc, and the market is competitive. Not all providers are the same, of course, but people are rarely screwed by surprising characteristics of the product. Lots of primes are defaulting of course, but they are doing so for reasons they would have understood well ex ante: they can't make the monthly payment, even though it is the same payment they signed up to and paid their first month. They are not being screwed by prepayment penalties, resets, recasts, interest-rate spikes, etc. That primes are suffering in the quantity that they are is arguably a function of the popularity of nonprime products, which permitted higher effective leverage and therefore helped inflate a housing market primes had to compete in. (If all homebuyers had to put 20% down per supervanilla prime, there would have been no housing bubble.)

Anyway, my understand is that the vanilla rule would have been what you are calling the "silly vanilla rule". But you are wrong to do so. Such a rule would not be silly at all.

Ken Houghton remembers that Warren Buffett famously groused that he pays a lower percentage of his income in taxes than his secretary. Or the person who will come up with an actual cure for a cancer.

Mark Cuban takes this one step further, pointing out the obvious: if we want to promote investment, "we should tax the trader/speculator more heavily than the investor.[emphasis his]"

When you make the tax rate the same for short-term investment as long-term—and lower than that on income—you create the perverse incentive to taking profits in the short-term, making the "capital" investment equivalent to a Demand Deposit account. If you want to reward capital investment, it needs to be truly treated as capital. Cuban notes:

The government should raises taxes significantly on profits from short term capital gains on the sale of public stocks, indexes, commodities, futures held for 24 hours or less and extend the length of time required to qualify for Long Term capital gains and reduce the tax rate on Long Term gains.

It might be difficult to reduce the already-less-than-minimal tax rate on long-term gains. (Last time I checked, the capital gain on a five-year investment is taxed at 8%.) But it would be no problem at all raising the rate on short-term trades back to where it should be—above that of ordinary income tax rates. And even a budget-balancing approach would leave plenty of room to lower the rate for legitimately long-term holdings.

Cuban makes the connection: one of the reasons the tax incentives need to be moved is the perversion they have made of Corporate Governance:

[Raising taxes on short-term trades and lowering them on long-term investments] will also reward companies that act in the financial interests of long term holders and their employers. I think the impact on the economy would be far fewer layoffs as CEOs find themselves with more shareholders who think long term rather than short term. Believe it or not, there are shareholders who are fine with companies not beating their numbers if the company is making progress towards a clearly defined goal....Taxation can change the focus on public companies and stock trading. That would be a great thing for the economy.

Cuban notes that there is still the major problem of misaligned incentives in Executive Compensation (economist's version here [PDF, subscription required]):

CEOs...are so focused on marking to market their own personal stock portfolios, they emphasize stock performance over doing the right thing for the company.

Amazingly, this is exactly the problem that standard economic theory claims "professional" management solved. I hope this one makes it into John Quiggin's book.

From the coolest possibly-corporate-espionage story of the week:

If only the FBI were to tackle cases of national security and loss of life with the same speed and precision as they confront presumed high-frequency program trading industrial espionage cases... especially those that allegedly involve Goldman Sachs.

The original is from Reuters.

When I first heard that Michael Jackson died, I thought immediately of Chuck Sullivan. I met him once, probably in the early 1990s, after his sponsorship of The Jacksons's Victory tour savaged his fortune. Unlike the other Moguls I Have Seen, it seemed his reversal of fortune impacted his mood. (More likely, I just caught him on a bad day.)http://www.blogger.com/post-create.g?blogID=5048766

So I decided to do an AB post about the Victory tour, which was probably the beginning of the end for MJ's claim to being "the new Elvis," since it was the last time he toured with his family.

Fortunately, as my Loyal Reader (a loyal Patriots fan) notes, I don't have to. Chad Finn at the Boston Globe tells the story:

[A] disastrous business venture by the Sullivan family -- the founding owners of the franchise -- indirectly helped Kraft fulfill his dream of owning the Patriots....Charles Sullivan had used the stadium as collateral to fund the Jackson brothers' Victory Tour back in 1984. Over-leveraged, Sullivan went bankrupt and was forced to sell the arena.

The rest, as they say, is HIStory.

UPDATE: More discussion of the Victory tour, the Reagan Administration, and the bitter attitude of a future Supreme Court jutice at the NYT blog h/t Greg Mitchell's Twitter feed).

A correspondent notes CJR found a good scoop by the FT:

Merrill Lynch paid out about $4 billion in bonuses just days before Bank of America took it over, the Financial Times says this morning.

What raises the eyebrows is the timing: Merrill paid its bonuses before the year was even up, “an unusual step” because bonuses in past years weren’t paid until late January or early February.

But, of course, by then, the bonuses would have been under the auspices of Bank of America, since that deal closed 1 January 2009.*

My favorite pull quote combines issues of corporate governance, moral hazard, and risk (mis)management:

The timing is notable because the money was paid as Merrill’s losses were mounting and Ken Lewis, BofA’s chief executive, was seeking additional funds from the government’s troubled asset recovery programme to help close the deal.

Merrill and BofA shareholders voted to approve the takeover on December 5. Three days later, Merrill’s compensation committee approved the bonuses, which were paid on December 29.

I've never been a believer in Ken Lewis's alleged skills as a banker—his wins have been ones of sewlf-admitted collusion, while his "free market" purchases have generally been abject failures, the cost savings more than lost in knowledge failures—and this specific instance looks as if he got played badly.

If BofA paid or is paying retention bonuses as well, Lewis should be terminated with extreme prejudice and the entire BofA board should be removed by the shareholders.** It's not as if (it is filled with crack financial wizards.):

[T]he Bank of America board, whose ranks include the mayor of Spartanburg, S.C.; a retired general, Tommy R. Franks; and the former chairman and chief executive of Lowe’s....

*BofA, memory serving, pays its bonuses in early February—but one somehow suspects that the question would not have been about the timing of the payments.

**I was going to say "with pitchforks, if necessary," but that might be taken as extremism, since we're not talking about civilians.

There is a reason I never believe people who judge the health of a company by its credit rating: the evidence isn't there, and everyone in the market knows it isn't there.

Here is a prime example: General Electric (GE; the company that Jack eviscerated) has a AAA credit rating. It is also paying a 31 cent per share quarterly dividend.

The stock is trading at $12/share as I type.

That's a yield of 10.31%, per MarketWatch.

The 30-year Treasury, as I write (presumably the Friday close) is yielding 3.32%.

Rounding off—I doubt anyone would seriously quibble the basis point—we have an allegedly-AAA company whose stock is trading 7.00% above Treasuries. At a time when the average "redemption yield" for investment-grade bonds is 6.47%.


Now, in sane circumstances, people would be saying, "Oh, but that's because GE will, certainly, cut its dividend. And investors know that." However, CEO Jeffrey Immelt (the man charged with cleaning up Jack's mess, who instead compounded his predecessor's actions) assured investors that the dividend will not be cut, even as he noted that GE expects an "extremely difficult" 2009.

Moody's has GE on credit watch with "outlook negative," but they've only been there since 13 January 2009. This is a company that is paying about 15% of its net earnings out in dividends. Calling GE "not a growth stock" is like calling Sears anything other than a real-estate play: so bloody obvious that it shouldn't need to be said.

Yet, for some reason, it needed to be said. And Moody's is hanging there, ten days into "outlook negative" while the bleeding stock market is screaming "junk bond yield" on the equity.

Don't get me wrong; GE is probably still investment grade. Their store credit card business ownership of NBC and affiliates consumer products division defense contracts alone should keep them there. But that's what we said about GM too.

GM stock, which is the downside risk cited by MarketWatch, is currently yielding 28.5%. If General Electric (GE) were yielding that level with the current dividend, it would be priced around $4.35—about another 64% decline. [As noted in the comments, GM has suspended its dividend and actually yields nothing; the MarketWatch site for some reason reports the yield based on the suspended dividend anyway. -ATB]

If you're asking me, this points the way to a good piece of the other part of the "equity premium puzzle." But more on that in a later post.

Robert Waldmann

Brad DeLong boldly attempts to exhaustively list the factors which can affect the value of a fixed income asset. This is some Mac generated i document and I can't cut and paste. Go here and search for "there are four".

The four are called "default", "the safe real interest rate", "risk", and adverse selection.

I view the assertion that "there are four" as a challenge and quibble after the jump.



First the instruments in question promise nominal payments so the safe interest rate in question is the safe nominal interest rate not the safe real interest rate. The word "real" is essentially a typo.

Second "default" and "risk" are the same things for fixed income instruments (clearly what Brad is discussing). By "risk" I assume he means "risk bearing capacity" or "risk aversion". However, default is a much broader problem than Brad seems willing to admit. He counts exactly two sources of default risk -- 1 trillion in housing related defaults and 3 more trillion from defaults caused by the recession. This leaves out other sources of changes in estimated default risk (not risk aversion or risk bearing caspacity but risk).

That is, I see a fifth cause of the decline in asset values. I think many assets were over-valued in the past, because the ratings agencies were tricked or cashing in on their late lamented excellent reputations (or both). The loss of confidence in said agencies causes an increase in estimated risk not because risk has increased or risk aversion has increased but because the old estimates are now known to be bogus.

More generally, risk modeling by traders was similarly complete nonsense. I don't know to what extent the traders were tricked and to what extent they were in on the scam (nor I suspect do they).

Structured finance created a huge illusion of wealth by creating an illusion of safety. The financial engineers knew how the agencies rated (the agencies explained for a consulting fee) and how traders estimate "value at risk". They knew people assumed (or pretended to assume) that all stochastic variables are normally distributed. Thus it was profitable to sell instruments with skewed returns (fat lower tails) unless the rare negative event occurred during the testing period (in which case the instruments could be re-engineered). A senior tranche of a pool of moderately risky assets has a skewed distribution.

Similarly money could be made by reducing own variance for a given beta by pooling assets and issuing claims on the pool. The variance of an average is less than the average variance. The covariance of an average and the market portfolio is the average covariance. Thus a claim on a pool of BBB rated corporate bonds was rated AAA. Turning BBB to AAA is worth a lot of money except for the fact that it was a scam (investors could pool themselves -- they don't seem to have understood that pre-pooling reduces the benefit to them of their own pooling -- or they were in on the scam).

That is there were trillions of fantasy dollars created out of nothing by financial engineering (on top of whatever real wealth had been created by financial engineering which genuinely made better insurance and diversification possible). The loss of that illusion can't be estimated easily as "housing related defaults" (and note my example has nothing to do with housing or recessions).

The risk of a nationwide decline in house prices was estimated at 0 by S&P (I am not exaggerating). Now there has been such a decline, and they must admit that there is the risk of another such decline in the future. Even if the current decline costs just $ 1 trillion, the future possible declines also cost money.

So much of the wealth was an illusion which won't come back soon. This end of systematic miss-estimation of risk is not on your list.

Also institutions took huge gigantic bets against each other (as in AIG lost writing CDSs). This increases counter party risk. No one knows if a counter party is solvent. That reduces the value of a huge number of instruments. The damage could have been done without involving the housing industry or the stock market if, say, investment bank CEOs played a really high stakes poker game and all claimed to have won money. Also bankruptcy is costly. Even if the CEOs had played hundred billion ante poker on camera, wealth would have been destroyed and more wealth would have been shifted from investors to lawyers. This is another item not on your list.

Finally, much of the strange new finance was designed to help agents avoid prudential rules and regulations which they considered to be costly. Now they have learned two things. First that the regulations weren't so pointless so they will have to pay that cost to avoid bankruptcy. Second they will be audited by banking regulators, trustees etc and found wanting. This last point is semi redundant as it amounts to an increase in perceived risk or a reduction in perceived capacity to bear risk (default or risk in Brad's terms). However, it explains why I keep speculating that this that or the other operator was in on the scam.

UPDATE: DeLong indirectly replies here. [klh]

All (somewhat***) via Mark Thoma:

Thomas Frank in the WSJ tells me why I always disagree with Robert (and the Other Economists) on the role of rating agencies:

And who makes sure that Moody's and its competitors downgrade what deserves to be downgraded? In 1999 the obvious answer would have been: the market, with its fantastic self-regulating powers.

If you look at the spreads of various debt products, you can see that the market was doing that type of job even in 2007. For instance, the debt market priced ["rated"] Bear Stearns's five-year bond issue in August 2007 at 245 over: rather closer to "junk" status than its rating would have implied. If you compare the debt and stock markets, it's easy to see which is closer to "rating." Unfortunately, the area where information is more valuable* is not the one discussed and understood in the press, where BSC kept trading up for several more months.

If a market "regulates" but no one notices, does it make the WSJ?

Brad Setser finishes the destruction of Tyler Cowen's LTCM "argument" begun by Buce, while revealing its underbelly:

The big banks called to the New York Fed were the creditors of LTCM and they were in some sense “bailed-in.” To avoid taking losses on the credit that they had extended to LTCM, they had to pony up and recapitalize LTCM. [footnoted exception for BSC]

It just so happened that the market recovered and it was possible for LTCM to exit many of its positions without taking large losses, or in some cases any losses. The banks that took control of LTCM when LTCM was on the ropes were able to unwind LTCM’s portfolio in a way that didn’t result in additional losses. But the result Cowen desired — large losses for the banks and broker-dealers who provided credit to LTCM – was quite possible if LTCM’s assets weren’t sufficient to cover all its liabilities. No creditor of LTCM was able to get rid of its exposure as a result of the Fed’s actions. [emphases mine]

It used to be a standard rule that if you wanted to bury something in a newspaper, you published it on a Friday, or the day before a holiday. This seems to be what the NYT is doing with Casey Mulligan (previously discussed here here), who dropped the other shoe yesterday and was, amazingly, worse than expected. PGL at Econospeak does the read and calls out the deed:

Mulligan is essentially saying that those poor saps who have lost their jobs actually quit so they can game the mortgage system. In other words, there is no such thing as involuntary unemployment or being forced to either lose one’s home versus enter into one of these mortgage modification programs.

As noted in the WaPo two weeks ago (via Stan Collender at Capital Gains and Games),** qualifying for the "mortgage modification" program (i.e., reducing the principal on your loan to not more than 90% of the current market value) is an onerous task:

He was hoping he could qualify for the federal government's Hope for Homeowners program, which allows the Federal Housing Administration to insure a new mortgage if the lender voluntarily writes down the mortgage principal to 90 percent of the new value of the home. But when he asked his bank about that, he was told he would have to be on the brink of foreclosure or have an adjustable-rate mortgage.

So Mulligan is basically blaming (1) those whose ability to keep their home depended on keeping their job and (2) those who took Alan Greenspan's venal advice to go into ARMs just at the point at which he started raising rates. Class act.

And, finally, lest you think I'm always bashing Tyler Cowen, he notes a phenomenon in chess and suggests a reasonable conclusion:

I also see a general principle operating: the more exact a "science" the game becomes, the smaller is the value of accumulated experience relative to sheer skill.

The sheer is dicey, but the identification of the shift in proportionality may be accurate, and probably has applications in economics as well.

*The debt market is less liquid and therefore considers information more valuable. This is effectively the corollary of the DeLong, Shliefer, Summers and Waldmann papers: if you can't depend on momentum trading, you take more care not to be the "greater fool."

**Yes, I saw the Collender-bashing in my previous post. I've said before that CG&G became significantly less readable after the election, and am foolishly optimistic enough to believe that they may be returning to rationality. Besides, he happened to be correct: any given from increased military spending is definitionally no better (and likely worse) than spending the same amount on public infrastructure.

***I read PGL's piece before seeing it in the links, but they're all there.

sc, commenting at Alea on September 24th, was much better:

How to play this to make money? GLD and SKF (if it starts behaving properly) and OTM [out of the money] puts on C, BAC, WB.

That last is WalkAllOverYa, which is either WFC or Big C bound, depending on time of day, phase of the moon, and how obvious John McCain's Stage IV melanoma and or TIA attacks are. I'm leaving it out of the graphic below because it has dropped too much, even compared to The Big C.

The current results (click to enlarge and see Sep 24 prices):

sc, commenting at Alea on September 24th, was much better:

How to play this to make money? GLD and SKF (if it starts behaving properly) and OTM [out of the money] puts on C, BAC, WB.

That last is WalkAllOverYa, which is either WFC or Big C bound, depending on time of day, phase of the moon, and how obvious John McCain's Stage IV melanoma and or TIA attacks are. I'm leaving it out of the graphic below because it has dropped too much, even compared to The Big C.

The current results (click to enlarge and see Sep 24 prices):

Stormy noted that Wells Fargo's bill is based in part on "exploiting a presumed tax loophole."

I forgot to ask the question one should always ask when confronted with a Chess Ending problem, "What was the move before?"

In this case, we know (from A C Shareholder's comment) that Wells had been discussions to purchase "WalkAllOverYa" last weekend. But they didn't commit then, while, suddenly, Friday, they did, in what the Wall Street Journal editorial page would like us to believe is an example of free-market capitalism coming to the rescue:

A better canary in the cyclone is Thursday night's news that Wells Fargo has agreed to buy Wachovia for $15.4 billion and without any government involvement. Only Sunday night, Wells Fargo had backed out of a similar deal for a higher price.

Without any government involvement? Marcy Gordon of BusinessWeek (h/t Mark Thoma) sets the record straight:

On Tuesday, the Internal Revenue Service issued guidance boosting banks' ability to offset the losses from loans and other bad debts held by other banks they acquire. The guidance allows banks to take larger tax write-offs against future profits....

Before the IRS ruling this week, there were limits on the amount of certain losses that an acquiring bank could write off against post-combination profits. Now those limits have been suspended, said Jeff Harte, an analyst at Sandler O'Neill.

With banks suffering billions in losses from soured mortgage-related assets, the IRS move "potentially increases buyers' ability to realize tax benefits from bank acquisitions," Harte wrote in a note issued Friday. The change "could spur significant bank industry consolidation," he said.

"We suspect that the new IRS guidance allowed Wells Fargo to place a higher bid for Wachovia today than it might have been willing to a few days ago," Harte said.

And who was responsible for the IRS announcement? Mark Sunshine, guest-blogging at the NYT Economix blog, suggests it was Secretary of the Treasury Paulson:

But Mr. Paulson’s fiscal-stimulus work didn’t end with the bailout bill.

With hardly anyone noticing, on Wednesday he pushed through very technical and obscure changes to tax regulations that provide a "tax subsidy" for acquirers of troubled banks. Just as automakers stimulate car sales through rebate checks, the Treasury is providing a form of tax rebate to acquirers of troubled banks. Everyone can thank Hank Paulson and his stealth tax-driven fiscal stimulus for the astonishing news that Wachovia was being acquired by Wells Fargo and not Citigroup. It was Mr. Paulson’s tax subsidy to Wells Fargo that provided the fiscal grease to make this deal happen. Pundits who point to the deal and proclaim that the "free markets work without government help" don’t understand the motivating effect of several billion dollars of tax benefits to Wells Fargo.

Couldn't have said that last better myself.

Stormy noted that Wells Fargo's bill is based in part on "exploiting a presumed tax loophole."

I forgot to ask the question one should always ask when confronted with a Chess Ending problem, "What was the move before?"

In this case, we know (from A C Shareholder's comment) that Wells had been discussions to purchase "WalkAllOverYa" last weekend. But they didn't commit then, while, suddenly, Friday, they did, in what the Wall Street Journal editorial page would like us to believe is an example of free-market capitalism coming to the rescue:

A better canary in the cyclone is Thursday night's news that Wells Fargo has agreed to buy Wachovia for $15.4 billion and without any government involvement. Only Sunday night, Wells Fargo had backed out of a similar deal for a higher price.

Without any government involvement? Marcy Gordon of BusinessWeek (h/t Mark Thoma) sets the record straight:

On Tuesday, the Internal Revenue Service issued guidance boosting banks' ability to offset the losses from loans and other bad debts held by other banks they acquire. The guidance allows banks to take larger tax write-offs against future profits....

Before the IRS ruling this week, there were limits on the amount of certain losses that an acquiring bank could write off against post-combination profits. Now those limits have been suspended, said Jeff Harte, an analyst at Sandler O'Neill.

With banks suffering billions in losses from soured mortgage-related assets, the IRS move "potentially increases buyers' ability to realize tax benefits from bank acquisitions," Harte wrote in a note issued Friday. The change "could spur significant bank industry consolidation," he said.

"We suspect that the new IRS guidance allowed Wells Fargo to place a higher bid for Wachovia today than it might have been willing to a few days ago," Harte said.

And who was responsible for the IRS announcement? Mark Sunshine, guest-blogging at the NYT Economix blog, suggests it was Secretary of the Treasury Paulson:

But Mr. Paulson’s fiscal-stimulus work didn’t end with the bailout bill.

With hardly anyone noticing, on Wednesday he pushed through very technical and obscure changes to tax regulations that provide a "tax subsidy" for acquirers of troubled banks. Just as automakers stimulate car sales through rebate checks, the Treasury is providing a form of tax rebate to acquirers of troubled banks. Everyone can thank Hank Paulson and his stealth tax-driven fiscal stimulus for the astonishing news that Wachovia was being acquired by Wells Fargo and not Citigroup. It was Mr. Paulson’s tax subsidy to Wells Fargo that provided the fiscal grease to make this deal happen. Pundits who point to the deal and proclaim that the "free markets work without government help" don’t understand the motivating effect of several billion dollars of tax benefits to Wells Fargo.

Couldn't have said that last better myself.

A detail of tax law makes all the difference in Stormy's post below. Buy the whole thing, get the tax break. Buy part of it, you don't.*

The other half of the answer is that "timing is everything." And playing Chicken with the FDIC often has Unintended Consequences.** So let's turn the continuous-not-discrete timeline details over to reader A C Shareholder in comments to Stormy (minor edits for style):

While obviously I am biased because Wachovia stole 20% of my equity value on Friday, I do think it's always fun to watch the Monday morning quarterbacks talk about Wells Fargo as if they only needed a little more time.

When you are dealing with a bank run, you do not have a "couple of days." The "couple of days" was the FDIC trying to get Wachovia and Wells Fargo together starting on the Thursday before last weekend and then Wells bailing around Saturday night, Sunday morning. Wells Fargo played chicken with the FDIC by walking away. Do not believe for a minute that walking away from the table wasn't a a calculated move designed to put Wachovia in receivership a la WaMu. The only problem was Wells didn't foresee Citi putting a deal together that quickly.

So let's try to construct what would have happened last weekend if Citi doesn't step in. Wells leaves Wachovia at the altar Sunday night. Not a great sign of confidence for Wachovia. Market and business opens on Monday. Everyone had been anticipating a deal over the weekend—without one, CFOs and Treasurers get antsy. Noon, the House votes down the bailout package. Immediately, wire and ACH transactions begin hammering Wachovia. Suppose they get through the day, overnight banks refuse to lend to Wachovia. Wachovia's funding dries up (look at LIBOR and the TED spread). Tuesday, money continues to pour out of Wachovia. After a brief pop, the market is hearing more about Wachovia precarious position and starts trending lower. Without funding sources, Wachovia is at the Fed window for all monies. Tuesday overnight, still Wachovia cannot borrow from its peers—deposit base is down 15 - 20 billion. Wednesday, FDIC seeing that the market has lost confidence in Wachovia steps in and puts Wachovia into receivership.

As for the FDIC's ability to get anymore deals done, it doesn't absolutely stop them. However, now all deals will be receivership deals like WaMu. Wells, Chase, and BofA are all just under or over the 10% deposit base limit so none of them have the ability to merge anymore. The only bank with the ability to merge balance sheets is Citi. As for the others (US Bancorp, PNC, and BB&T), they may be able to do something but they have much smaller asset base in which to spread out losses. If you are VikrAm Pandit, are you going to do another OPEN transaction again with the FDIC or are you going to have the FDIC put 'em in a body baG and wipe out all debt and equity holders? Every regional bank shareholder that goes to receivership from here on out can thank Wells and Wachovia when there debt and equity gets wiped out.

So in return for my use of capital and stock last week that came in at the 11th hour and saved Wachovia and then floated them for an entire week of the worst funding environment in decades perhaps ever - I get a 20% loss as the CEO of Wachovia was smiling and grinning as late as Thursday. This knife in my back belongs to Wachovia's CEO Steele.

*This is nothing Citigroup wouldn't have known. The next step in the process is to realize that C valued the non-banking operations of "WalkAllOverYa" at less than the net value of the tax break. The implications of that are left to the reader. UPDATE: This is not necessarily so—see my follow-up post—they valued the net value of the non-banking operations as less than the Expected tax break's value, which was even lower than the value Wells is using.

**In this case, we have to assume the consequences really were Unintended, since assuming that Citigroup would buy the banking operations if Wells walked away would—as has become the case—make the acquisition more difficult for Wells. Which is as it should be.

A detail of tax law makes all the difference in Stormy's post below. Buy the whole thing, get the tax break. Buy part of it, you don't.*

The other half of the answer is that "timing is everything." And playing Chicken with the FDIC often has Unintended Consequences.** So let's turn the continuous-not-discrete timeline details over to reader A C Shareholder in comments to Stormy (minor edits for style):

While obviously I am biased because Wachovia stole 20% of my equity value on Friday, I do think it's always fun to watch the Monday morning quarterbacks talk about Wells Fargo as if they only needed a little more time.

When you are dealing with a bank run, you do not have a "couple of days." The "couple of days" was the FDIC trying to get Wachovia and Wells Fargo together starting on the Thursday before last weekend and then Wells bailing around Saturday night, Sunday morning. Wells Fargo played chicken with the FDIC by walking away. Do not believe for a minute that walking away from the table wasn't a a calculated move designed to put Wachovia in receivership a la WaMu. The only problem was Wells didn't foresee Citi putting a deal together that quickly.

So let's try to construct what would have happened last weekend if Citi doesn't step in. Wells leaves Wachovia at the altar Sunday night. Not a great sign of confidence for Wachovia. Market and business opens on Monday. Everyone had been anticipating a deal over the weekend—without one, CFOs and Treasurers get antsy. Noon, the House votes down the bailout package. Immediately, wire and ACH transactions begin hammering Wachovia. Suppose they get through the day, overnight banks refuse to lend to Wachovia. Wachovia's funding dries up (look at LIBOR and the TED spread). Tuesday, money continues to pour out of Wachovia. After a brief pop, the market is hearing more about Wachovia precarious position and starts trending lower. Without funding sources, Wachovia is at the Fed window for all monies. Tuesday overnight, still Wachovia cannot borrow from its peers—deposit base is down 15 - 20 billion. Wednesday, FDIC seeing that the market has lost confidence in Wachovia steps in and puts Wachovia into receivership.

As for the FDIC's ability to get anymore deals done, it doesn't absolutely stop them. However, now all deals will be receivership deals like WaMu. Wells, Chase, and BofA are all just under or over the 10% deposit base limit so none of them have the ability to merge anymore. The only bank with the ability to merge balance sheets is Citi. As for the others (US Bancorp, PNC, and BB&T), they may be able to do something but they have much smaller asset base in which to spread out losses. If you are VikrAm Pandit, are you going to do another OPEN transaction again with the FDIC or are you going to have the FDIC put 'em in a body baG and wipe out all debt and equity holders? Every regional bank shareholder that goes to receivership from here on out can thank Wells and Wachovia when there debt and equity gets wiped out.

So in return for my use of capital and stock last week that came in at the 11th hour and saved Wachovia and then floated them for an entire week of the worst funding environment in decades perhaps ever - I get a 20% loss as the CEO of Wachovia was smiling and grinning as late as Thursday. This knife in my back belongs to Wachovia's CEO Steele.

*This is nothing Citigroup wouldn't have known. The next step in the process is to realize that C valued the non-banking operations of "WalkAllOverYa" at less than the net value of the tax break. The implications of that are left to the reader. UPDATE: This is not necessarily so—see my follow-up post—they valued the net value of the non-banking operations as less than the Expected tax break's value, which was even lower than the value Wells is using.

**In this case, we have to assume the consequences really were Unintended, since assuming that Citigroup would buy the banking operations if Wells walked away would—as has become the case—make the acquisition more difficult for Wells. Which is as it should be.

Almost a week ago—a few decades of Internet time, when people could still believe House Republicans might be sane—Brad DeLong quoted the summary:

To provide authority for the Federal Government to purchase certain types of troubled assets for the purposes of providing stability to and preventing disruption in the economy and financial system and protecting taxpayers, and for other purposes...

As noted, this was back before "other purposes" included cutting down more trees in Oregon or providing mental health benefits as part of insurance. So let's just focus on the word that makes this facility different: purchase.

And let's put that $700,000,000,000 in a context (figures in $Billions):

So we could buy four of the largest banks and the three somewhat-remaining large Investment Banks with change left over.

But that wouldn't get market lending started again.

Will buying securities?

More on Next* Rock...

*A following, not to be taken literally as "next."

Almost a week ago—a few decades of Internet time, when people could still believe House Republicans might be sane—Brad DeLong quoted the summary:

To provide authority for the Federal Government to purchase certain types of troubled assets for the purposes of providing stability to and preventing disruption in the economy and financial system and protecting taxpayers, and for other purposes...

As noted, this was back before "other purposes" included cutting down more trees in Oregon or providing mental health benefits as part of insurance. So let's just focus on the word that makes this facility different: purchase.

And let's put that $700,000,000,000 in a context (figures in $Billions):

So we could buy four of the largest banks and the three somewhat-remaining large Investment Banks with change left over.

But that wouldn't get market lending started again.

Will buying securities?

More on Next* Rock...

*A following, not to be taken literally as "next."

Via Dr. Black, from Google Finance, the charitable interpretation of what was done this afternoon is the old Wall Street adage above (click on image to see it well):

Via Dr. Black, from Google Finance, the charitable interpretation of what was done this afternoon is the old Wall Street adage above (click on image to see it well):

I have a cold, or perhaps a touch of the flu, so posting will be light for the next few days. Especially if this is true, which somewhat means the election is over and I can go back to looking at data and hoping the House fails to pass the Christmas Card list bill.

But I do want to make it clear that, if I get a call the day after the election (from either party), I will move back down and accept this job.

I have a cold, or perhaps a touch of the flu, so posting will be light for the next few days. Especially if this is true, which somewhat means the election is over and I can go back to looking at data and hoping the House fails to pass the Christmas Card list bill.

But I do want to make it clear that, if I get a call the day after the election (from either party), I will move back down and accept this job.