Kevin Drum

Basel Squared

| Mon Apr. 27, 2009 12:35 PM EDT

Ezra Klein gets geeky:

One of the pieces of the crisis that I hadn't understood until recently, for instance, was the role that Basel II banking regulations played in the growth of the structured securities market. In essence, Basel II, which went into effect a couple years ago, held that a bank only had to keep half as much capital on hand for AAA-rated securities as for other types of assets. That created a huge incentive for banks to get more things rated AAA....

And that in turn made the creation of allegedly AAA-rated securities a growth industry.  If a bank holds a $100 BBB-rated security, for example, they're required to maintain $8 in capital reserves to back it up.  However, if they ring up their friendly broker at AAA-rated AIG and buy a credit default swap on that bond, it's suddenly rated AAA too and the bank only has to hold $1.60 in capital.  That $6.40 freed up, and with leverage of 20:1 that's $128 available for productive investments in America, my friend!  What a bargain.

(Though it's worth noting that European banks engaged in this kind of regulatory arbitrage at least as much as American banks.  Maybe more, in fact, which is why AIG ended up paying out so much money to Société Générale and Deutsche Bank.  American banks have gotten the lion's share of the attention so far for their shoddy asset portfolios, which is fair enough since America was the focal point for the subprime crisis, but European banks were pretty eager consumers of regulatory shenanigans as well.)

In any case, there are plenty of reasons to be skeptical of Basel II, and among other things it goes to show the difficulty of setting international standards in the world of finance.  One of the reasons Basel II is weaker than Basel I is that every country has its own financial industry idiosyncracies, and every country wants banking accords to treat their particular idiosyncracies lightly.  Basel II did that, and then took things even further by allowing banks to use their own internal models for credit risk because, you know, internal models had proven themselves so sophisticated and reliable.  Oops.

On the other hand, the Basel II accords weren't even published until 2004, and didn't get adopted in most countries for several years after that.  As weak as Basel II is, the credit bubble and its associated financial rocket science far predates it.  I'm not really sure how far you can go in blaming it for our current meltdown.

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Hunkering Down

| Mon Apr. 27, 2009 11:40 AM EDT

Lawrence Wilkerson, Colin Powell's former chief of staff, thinks we need a special prosecutor to investigate Bush-era torture policies.  My MoJo colleague David Corn, the guy who first broke the Valerie Plame story, isn't so sure:

There's one problem with a special prosecutor: it's not his job to expose wrongdoing. A special prosecutor does dig up facts — but only in order to prosecute a possible crime. His mission is not to shine light on misdeeds, unless it is part of a prosecution. In many cases, a prosecutor's investigation does not produce any prosecutions. Sometimes, it leads only to a limited prosecution.

That's what happened with Patrick Fitzgerald. He could not share with the public all that he had discovered about the involvement of Bush, Cheney, Karl Rove, and other officials in the CIA leak case. Under the rules governing federal criminal investigations, he was permitted to disclose only information and evidence that was directly related and needed for the indictment and prosecution of Libby. Everything else he had unearthed via subpoenas and grand jury interviews had to remain secret. Repeatedly, Fitzgerald said that his hands were tied on this point. A special prosecutor, it turns out, is a rather imperfect vehicle for revealing the full truth.

David also says that lawyers he's talked to suggest that prosecutions would be difficult, which could leave us in the worst of all possible worlds: a long, drawn-out investigation that, in the end, produces not even a report or a set of indictment, let alone convictions.  No one would be satisfied.

David suggests an independent commission of some kind as the best way forward, and I'm tentatively inclined to agree.  Unfortunately, President Obama seems distinctly non-thrilled by the idea, and I doubt that Congress is especially eager to move forward either.  Porter Goss's op-ed last Friday in the Washington Post, where he insisted that both Democratic and Republican members of Congress knew what the CIA was doing and didn't object to it, may have been disingenuous in places, but I wouldn't be surprised if he's right about his essential point — or at least, close enough to right to make a genuinely independent commission as frightening a prospect for Dems as it is for the GOP.  It's probably the right thing to do, but if Obama's opposed and Republicans are opposed and Democrats are mostly running for cover, who's going to make it happen?

There's always the Senate Intelligence Committee, of course, but I wouldn't hold my breath that they're going to produce anything definitive.  Washington is hunkering down and hoping that this will all blow over as soon as the next crisis of the moment hits the front pages.  Unfortunately, they're probably right.

Withdrawing from Iraq

| Mon Apr. 27, 2009 10:48 AM EDT









Miscellaneous Thoughts

| Mon Apr. 27, 2009 12:02 AM EDT





Normal blogging will resume Monday.


Friday Cat Blogging - 24 April 2009

| Fri Apr. 24, 2009 9:00 AM EDT




Stress Test Update

| Fri Apr. 24, 2009 12:06 AM EDT







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Contrafactual of the Day

| Thu Apr. 23, 2009 7:58 PM EDT

James Surowiecki sez:


Is this true?  Discuss.

Quote of the Day - 4.23.09

| Thu Apr. 23, 2009 4:47 PM EDT

From Barclays analyst Craig Huber in a research note:




| Thu Apr. 23, 2009 2:22 PM EDT

Like pretty much everyone else on planet Earth, I've been thinking about risk a lot lately.  And I suppose I've been thinking pretty much the same thing as everyone else.  The following excerpt, from a speech to a bunch of bond dealers, is a bit jargony, but gets the basic point across.  Take it away, Felix Salmon:





Of course, we all know how reliable those monoline guarantees turned out to be — and that’s a related story. The monolines, just like the ratings agencies, believed far too much in the power of models.

This kind of thing isn't new.  The basic idea is that you take, say, a BBB-rated bond (decent quality but not great) and get a monoline to insure it, and suddenly you've got a AAA bond.  It's now risk free because even if the bond defaults, the monoline will pay you off.  In theory, this is great: somebody who wants less risk in their portfolio is able to buy insurance from someone who wants more risk in return for a greater potential return.  Everybody gets what they want — party A gets exactly the investment it wants and party B gets exactly the investment it wants — which makes the bond market more efficient and more liquid.

But although this is true theoretically, in the real world it turns out that risk is usually best measured by whoever is closest to it.  In the past, bond buyers were pretty careful about evaluating default risk because they were the ones who'd have to bear it.  Then they started selling off that risk, and the monolines, who were eager for business and comforted by the fact that their models had always worked, were just a little less careful.  Then credit default swaps were invented and popularized, and risk was sold off even further.  And then further.  And when you get three or four steps down the line, nobody is seriously analyzing the underlying securities themselves.  They're just relying on increasingly on abstract models.

So a system that theoretically makes the market more efficient ends up, for all too human reasons, with no one truly evaluating the risk of all the securities underlying the rocket science.  And eventually it comes crashing down.

All of which makes me wonder: is Felix still as bullish about credit default swaps as he has been in the past?  Unlike some credit derivatives, there's no question that CDS serves a useful purpose.  In theory.  But in practice, when their use becomes nearly universal and they start getting packaged two and three vehicles deep, they're deadly even if there's no conscious fraud or abuse going on.  They don't so much allocate risk as simply encourage people to ignore it.  It's just human nature.

As for me, I'm increasingly wondering if insurance of financial assets (as opposed to physical assets, which are a different story) is a good idea, period.  Sure, the upside is that it makes debt markets more efficient, but it's worth asking if we even want these markets to be more efficient in the first place.  What has that gotten us aside from gigantic profits for financial firms?  And if there's no upside to balance a potentially catastrophic downside, why allow it at all?  Maybe, human nature being what it is, there's no substitute for forcing debt buyers to be extremely, personally, conscious of the risk they're assuming when they make an investment.  Maybe, in the end, that's the only thing that can keep a credit bubble from overinflating.

I'm not sure.  Pushback welcome on this score.  But it's certainly worth thinking about the big picture here.

Chart of the Day - 4.23.2009

| Thu Apr. 23, 2009 12:01 PM EDT

Just kill me now.  Via The Monkey Cage.