A Sit Down with 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 written 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 whoas" and a murmur from a number of STOs 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, BofA (BAC) and CITI (C)) 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.

Comments

[fed_alchemy]

Did you wash your hands afterward that radioactive thallium is hard to get off.

2009 Nov 05 05:10 AM

[a fat panda]

There is an old saying, "Better to be thought a fool than to open your mouth and remove all doubt" that comes to mind. But it doesn't do justice to inviting bloggers to the Treasury. So the new saying will have to be created :

"Better to be thought corrupt or fool by bloggers, than to invite them to ask questions for which you are not prepared and let the rest of the world in on the secret of how truely stupid you are".

What did they expect? They wanted to give you a hug and have you go away.

2009 Nov 05 07:01 AM

[Screwloose]

Good job they didn't invite Denninger....

.

2009 Nov 05 08:49 AM

[greaterdepression]

They have begun your "capture". You probably enjoyed your visit with these polished people in their impressive conference room. They will invite you back, and you will start to look forward to this "access", and the story which you can write upon your return. You may see photos of the children of these Treasury people, and share some personal stories. You may begin to moderate some of your statements to avoid losing this access and avoid offending these "nice people".
You have been captured.

2009 Nov 05 08:57 AM

[jupiter9604]

If your treasury briefing was a useless as the ones they give to msm, then there was nothing to learn. they sold msm the stress test non-sense months ago; geithner and bernanke were hostile to questions regarding the usefulness of same with bernanke actually blurting out, "we're in a recession" at one point. No " " Sherlock..but lying to the media and pulling wall st shenanigans...like muddying the water with needless complexity...is not going to increase anyone's confidence. Treasury "access" is overrated because Treasury Officials offer canned answers designed to obscure and not enlighten. No one at the FED or Treasury should be surprised that Consumers are calling for their heads ...and have no confidence. Consumers (taxpayers) see billions of dollars propping up banks that refuse to lend to them while racking up record profits for themselves! Fed and Treausry officials will not even address this glaring problem except for the "wet" and "whiney" ..."we did not want to have to do this (prop up banks, bail out car companies, own the abs mkt, etc) but we were forced into it". What should the government do now that they've knitted themselves into a cat's cradle?...just purr and think about their post government jobs!

2009 Nov 05 09:28 AM

[Pat C]

Great job, keep it up. Mainstream media just doesn't get it or doesn't take the time to get it. The administration needs to hear it from informed bloggers. Looking forward to Part II.

2009 Nov 05 09:29 AM

[Kid Dynamite]

i understand your point, and another attendee, Steve Waldman, mentioned that in his recap, here:

interfluidity.powerblo...


On Nov 05 08:57 AM greaterdepression wrote:

> They have begun your "capture". You probably enjoyed your visit with
> these polished people in their impressive conference room. They will
> invite you back, and you will start to look forward to this "access",
> and the story which you can write upon your return. You may see photos
> of the children of these Treasury people, and share some personal
> stories. You may begin to moderate some of your statements to avoid
> losing this access and avoid offending these "nice people".
> You have been captured.

2009 Nov 05 09:32 AM

[JeffDB]

Thanks for an excellent recap of what would seem to have been a rather exceptional opportunity.

That is the type of knowledgeable, dogged journalism that we truly need. If allowed to continue it would be healthy both for the Treasury et al, investors and the general public.

I'm a little skeptical, but it's certainly a nice start.

2009 Nov 05 10:38 AM

[Roger Knights]

I hope every gov't. agency starts regularly holding these pajama parties (don't spare the cookies!) -- it's possible that some off-the-reservation ideas may percolate through the kapok, hopefully before the crisis hits.

2009 Nov 05 10:56 AM

[Robespierre]

I understand, though not first hand, that some times the "families" would invite their enemies to different social gatherings in very nice venues. Regardless of how nicely they behaved lets not forget what kind of "business" these people were involved in and to who do they were accountable. If they want to restore confidence then perhaps they should try to disclose the backs and forth that wen on between them and executives of GS when the decision to pay dollar for dollar took place. Until then, I for one will not believe a word that comes out of their mouths.

2009 Nov 05 05:43 PM

[THofler]

Nice, keep up the good work. I complete disagree with your blind faith in the value of mark-to-market accounting though. I also think some the more talkative short sellers like Einhorn are selling a particularly devious brand of dishonesty.

You really should carefully read Buffett's March 09 Berkshire letter to shareholders. Summary: He loves MTM because it causes stupid sell-offs in share price. He thinks MTM should NEVER be connected to regulatory requirements.

2009 Nov 05 11:09 PM

[rick12345]

Not a very objective summary of events by any means. All it shows is how you and your fellow bloggers played with each others doodles.

2009 Nov 06 02:24 AM

[Kid Dynamite]

yeah, Merkel's point was a good one where even if you're not going to require mark to market, you still need to require capital increases when asset values decrease - that's key.

I don't know why you bring in Einhorn as a bad guy - if only we'd listened when he warned us very early about Lehman, perhaps some of this could have been avoidable


On Nov 05 11:09 PM THofler wrote:

> Nice, keep up the good work. I complete disagree with your blind
> faith in the value of mark-to-market accounting though. I also think
> some the more talkative short sellers like Einhorn are selling a
> particularly devious brand of dishonesty.
>
> You really should carefully read Buffett's March 09 Berkshire letter
> to shareholders. Summary: He loves MTM because it causes stupid
> sell-offs in share price. He thinks MTM should NEVER be connected
> to regulatory requirements.

2009 Nov 06 09:00 AM

[Kid Dynamite]

another point, Thofler - it's not BLIND FAITH in MTM - but MTM gives a more realistic picture of the facts than hiding the data does! Ritholtz had a post about this today:

www.ritholtz.com/blog/.../

the key quotes:
"The aggressive lobbyists are pushing for less transparency, less accurate reporting, less accounting oversights."

"The view of the bankers is that the financial crisis did not stem from the fact that the banks made lots of bad loans and invested in dubious securities; it was caused by accounting rules that required disclosure when the losses began to mount.”"


On Nov 05 11:09 PM THofler wrote:

> Nice, keep up the good work. I complete disagree with your blind
> faith in the value of mark-to-market accounting though. I also think
> some the more talkative short sellers like Einhorn are selling a
> particularly devious brand of dishonesty.
>
> You really should carefully read Buffett's March 09 Berkshire letter
> to shareholders. Summary: He loves MTM because it causes stupid
> sell-offs in share price. He thinks MTM should NEVER be connected
> to regulatory requirements.

2009 Nov 06 10:23 AM