Housing Doom

Doom Transcripts: Index & Guide

Housing Doom is pleased to present a third selection from our under-construction transcript of the American Enterprise Institute’s October 9, 2009 event "No Way Out: Government Response to the Financial Crisis".¹ The event site has a number of resources, including an audio and video of the proceedings. There is as yet no official transcript.

This is the impassioned Panel I  response to Vince Reinhart by IRA’s Chris Whalen.  Later today, less than 2 weeks after the "No Way Out" event, Chris will be rejoining the AEI subprime gang, including Nouriel Roubini, for "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis." Doomers in the DC area might want to take that one in.  Should be quite a show.

Chris Whalen: [0:49:23] … And I want to thank Vince for asking me to be with him today and to comment on his fine work. We were out in Chicago a couple of weeks ago, and one of the retired senior Fed officials who was there later remarked that I was one of the more reasonable attendees. And I think this is because the economists were still arguing over causation.

If you know anything about my writing or my history, that came as a surprise to me, but I’ll take the compliment.

What I would say to all of you today is I’d like to step back a little bit from this discussion, because … and I’ve seen Taleb’s first book, [0:50:00] The Black Swan. He talks about how people take complex situations and turn them into narratives in order to understand them. And they refine these narratives by speaking and writing and discussing their ideas amongst one another, and they eventually come up with a story that starts to look remarkably consistent no matter who you talk to. This is human nature.

I think the same thing is happening with this crisis. We, especially in the United States, have this wonderful tendency to look at everything from a vertical perspective, in silos. So we could somehow isolate monetary policy and bank supervision and fiscal policy into neat little boxes that are not at all disturbed by one another.

And in particular, when we hear people talking about foreign capital inflows, I want to scream, because those are our pieces of paper, we printed them, and they have come home looking for at least a nominal return. That’s why we have this problem, and I agree with the other speakers, I’m not sure how we deal with it, as long as the rest of the world is silly enough to allow us to have a monopoly on the means of exchange.

But I guess the way I look at this crisis is from a political perspective, because I think if you don’t understand the evolution of the United States and the change that is occurring in our society as we migrate from a democracy focused on individuals and individual’s liberty to a society which is growing more and more corporatist every day; more and more European every day. And I think this is reflected in the quiet but very intense debate going on in the regulatory community between Sheila Bair & the folks at the FDIC on the one hand, who represent a somewhat legalistic but traditional American view of banks and insolvency and resolution, and what I like to call the internationalist component, which is the Treasury & the Fed, who seem to know nothing about traditional American values, and who are aligning themselves with foreign nations, which are predominately socialist and authoritarian in nature.

I think you can tell whose side I’m on.

You know, it’s fascinating to me to see this, because I think a lot of the people at the Fed, who I love and respect, and I’ve worked with in the past, will recite this mantra about how certain banks are too big to resolve, too complex, plugged into too many clearing systems, etc. etc. … And then I point them at Lehman Brothers and I say, "Well, Harvey Miller did a fine job; the folks at SIPC did a fine job; and the folks in the Southern District of New York did an extremely good job on a very complex insolvency. What was wrong with that?"

And they say, "Oh, well, it was so damaging to the system. It damaged confidence." And we heard Vince mention sacred confidence in his comments. We must avoid damaging confidence, right?

Well if we have that as our rule, then we will never have a market system, because markets have to go from exuberance to terror in order to function. And if we do not have both, then we do not have a free market society. And if we’re going to allow our government to make those rules, then I would suggest that we are not going to be a democracy for much longer.

Just look at Europe. Do you really want to live in a society where the government excludes bad acts, excludes entrepreneurial activity in most industries and basically gives the populace a little bit of freedom now and then, right before elections usually, and then goes back to business soon thereafter.

Now Fed policy, I think, is really very much illustrative of one of the problems that we’re facing. I worked in the bank supervisionary of the Fed, and I don’t know how an agency can be both a monetary authority and a bank supervisor. Why? Well, because of the corporatist construction I just mentioned. We have three groups that are essentially running the show right now. We have a central bank that manages a fiat dollar system, which is totally inconvertable into anything. We have a Congress that equates the revenues from taxes with the proceeds of debt. They’re all one and the same to the Congress, and they’re allowed to do this because the central bank enables this.

Since the 1980s, really the late ’80s, when I was working on a trading desk at Bear Stearns, the central bank has never said "no" to the market, either with respect to collateral or liquidity. It’s only been a matter of price.

When was the last time we had a Fed Chairman stand up and say, "No." I would suggest it has been far too long.

So while the folks at the Fed can go on about how Chairman Greenspan couldn’t go up to the Hill and start saying mean things to members of Congress about housing policy, I think that’s precisely what we need.

If the heads of independent agencies aren’t ready to lose their job every day, when they come in the office, then they don’t belong there. And I would hold up Sheila Bair as somebody who’s willing to do that. The others are not, in my opinion.

And then finally we had the dealers. The dealer community, who are the recipients of the latest largess, sell the government’s debt. And they are [0:55:00] also the mechanisms through which the Fed executes monetary policy.

I would submit to you that the government, our elected political class, and the primary dealers are a tri-partite — I won’t say conspiracy, let’s call them an alliance of convenience — and they fit so beautifully in the now-corporatist mold that is America in the 21st Century, don’t they?

Now, let’s talk a little bit about the Fed’s role, because I think we spend far too much time talking about monetary policy, and not nearly enough about bank supervision, and particularly market structure.

You know, it’s very difficult to predict what’s going to happen when you have over-the-counter [OTC] markets, which are completely opaque. My clients trade Credit Default Swaps [CDSs] and they still can’t see the entire market every day; they’ve got to get on the phone and call around to various dealers for on-the-run instruments just to get an indicative price. Does that strike anybody in this room as strange? We’ve had public exchanges in this country for almost a century, and yet the Fed and the other regulators allowed our banking industry to install this hideous retrograde phenomenon called over-the-counter, both with respect to derivatives and structured assets.

So big surprise that we couldn’t see what was going on in these markets, and we couldn’t predict what would happen when the liquidity ebbed. There’s no suprise here, is there?

The reason we have opened our prime markets, and I said this in Chicago, is that they are an analog to something we all know very well, I hope, which is called checks and balances. The whole point of people standing in a room where they can see one another, and they can see who’s bidding on an asset, and then at the end of the day they can see the prices on every trade that occurred on that exchange, is the exact same reason why we have checks and balances in our political life, or we should.

When we go away from that model, we invite instability, we invite chaos, and we invite exactly what Vince was talking about before, which is the dimunition of confidence, and also the dimunition of credibility, which I value, frankly, much more than confidence.

Now we could talk about political capture. The only thing I’ll say about this is, look at the UK. In the UK, the gentleman who was put in charge of the cleanup cannot be approached by a bank. They may not speak to him. He is only answerable to the Prime Minister. All of the nationalized institutions in the UK are at his beck and call; they do what he tells them to do. End of story.

I got into a bit of a row with one of the attendees at Chicago when the issue of the President’s Working Group came up, and their role in helping to ameliorate the crisis, and I said, "You know, I can’t talk to the heads of bank regulatory agencies about policy matters, why should members of the President’s Working Group be able to go out and talk to the CEOs and minions of large financial institutions and evade those legal restrictions?" I have a big problem with the President’s Working Group, and I wish it would be put out of existence. It is totally inconsistent with our system to allow big corporations to circumvent the democratic limits that are placed on individuals.

And again I invite you to consider the difference between the democratic model that somebody like the FDIC has in mind when they are out regulating little banks, putting bondholders and shareholders to the sword, every day, or at least every Friday, and yet the big companies get a pass. And let’s be very specific. What are we talking about here? For the last year we have been subsidizing the bondholders of the biggest financial institutions by putting more public equity in front of them. There’s nothing fair about that.

So what should we do? Well, I have two very simple solutions. We should always be concerned and cautious about people offering simple solutions, but I think … you know, I’m not a fan of regulation, I don’t want to see any more regulatory layers put on our system, we don’t need them. We’ve already got plenty, and they’re completely useless.

I have two basic suggestions, and I’ve said them here at AEI in the past. First, anything that’s sold to a bank or pension fund has to be registered with the SEC, and I mean really registered; no more private placements. What that does, in a very simple sense, and I say this speaking as someone who’s worked in the securities industry for 25 years, is that it’s available to retail, and the lawyers and the banks won’t let them go beyond a certain degree of complexity because they’ll get sued.

We don’t need more regulation, the trial lawyers will do it very nicely, thank you. You just force Wall Street into that same registered template with everything they sell to what I call the least risk oriented, which are obviously public sector investors and banks, and we have no problems, because the hedge funds, the corporations, all the private players can do what they want. And frankly, I don’t want to regulate them. The idea of putting them [1:00:00] under the Fed is crazy.

The second issue, and I think this goes to all the talk about living wills and wind-ups and everything else. Look, we don’t want a wind-up Citibank, we don’t want to wind-up a money center institution and we shouldn’t even consider it.

What we have to do instead, I believe, is figure out a way to fund them when they get into trouble, and right now we don’t have a mechanism. Why?

Well, before the ’30s we had something called double liability stock. If you owned equity in a bank, you had to be ready to put a dollar in for every dollar you invested. So that if the bank got into trouble, they put out a call, you gave them more money, they doubled their capital. I think the debt of every bank holding company, at least in the United States, should be convertible into equity. We have baked-in resolution authority and we don’t even need more legal authority. If the bank becomes undercapitalized, the Fed can issue a cease-and-desist order, the institution turns to their investors, who may be in 10 percent increments — you convert it into equity.

We did that with Citibank, earlier in the year. Not only would our regulators have more credibility, but I think we’d have much more confidence in the markets today.

Convert a third of their debt into equity? You charge off $300 billion, which is more or less Citi’s holdings, and you’re left with the most solvent, liquid money center bank in the country.

It also has lower interest expense, by the way. And that’s one of the neat mechanisms of debt conversion.

Again, we don’t need legislation for this, and yet, frankly, if we had had different people in place over the last year we could have done something like that now, with no additional legislative authority. The Fed and the FDIC have the teeth.

And then finally, the last point I’ll make. You know we’ve been having hearings up on the Hill about OTC derivatives, and you can see the way this is going. I think we’d be better off with no legislation, frankly, given what I’m seeing from the Frank Committee.

I don’t know what to do in our system, I don’t know how we can insulate regulatory issues from our political process, but if you want to see the damage that’s being done by corporate interests in this very important public policy discussion, just look at the witness list from the Frank Committee. There are only 2 or 3 witnesses on that entire list that you could call critical spokesmen and intellectuals, people like Henry Hu, for example. The rest of them are just flacks for the dealer community.

So with that I will stop and I look forward to my colleagues’ comments. [1:02:23]

Notes and References

[1]: "No Way Out: Government Response to the Financial Crisis", AEI event homepage, October 9, 2009.