Archive for the ‘Wall Street’ Category

The Pretty Project: Day 55

October 19, 2009

someone asked me what animal I most resembled I would respond “Rattlesnake;” I think it goes without saying that a reptile of any kind is a frightening


The Pretty Project: Day 55

October 19, 2009

Keeping the financial system safe

March 22, 2009

Last week I discussed why capital requirements — requiring firms to have capital equal to some percentage of their assets — cannot prevent financial crises. Among other evasions, regulated firms can shift to riskier assets (such as subprime mortgages) within the asset categories defined by the regulations. Discretionary actions by regulators to offset such shifts during a bubble period would be extremely disruptive, requiring more foresight and political courage than we have any reason to expect from public servants.

Proposals have emerged to rectify these weaknesses of capital requirements by automating the adjustment process. This would require identifying one or more statistical measures to which capital requirements would be tied. When the measures indicated that a bubble was under way, capital requirements would increase automatically, and when the measures indicated that markets were contracting, requirements would decline.

While there are many good indicators of a contracting system that follows a bubble, there are no universal indicators of bubbles themselves. Bubbles can arise anywhere, and they can involve newly fashioned financial instruments that did not exist before. Because of this, automating capital requirements would not work.

The Alternative to Capital Requirements

A good alternative to capital requirements is transaction-based reserving (TBS). Under TBS, financial firms are regulated as if they were insurance companies that are obliged to contribute to a reserve account in connection with every asset they acquire. The portion of the cash inflows generated by the asset that is allocated to the reserve account depends on the potential future outflows associated with the asset. For example, a life insurance company that sells a policy to a 70-year-old will allocate a larger portion of the premiums it receives to a reserve account than the same policy sold to a 30-year-old.

As applied to a depository, the required allocation to a contingency reserve would be, say, 50 percent of the portion of any charge that is risk-based. If a prime mortgage were priced at 6 percent and zero points, for example, the reserve allocation for a 7 percent, 2 point mortgage might be ½ percent plus 1 point.

Contingency reserves can’t be touched for a long period, perhaps 15 years, except in an emergency. Of course, income allocated to reserves would not be taxable until it was withdrawn 15 years later.

The Great Advantage

A great advantage of TBR, relative to capital requirements, is that TBR does not depend on discretionary actions by the regulator to offset the excessive optimism that feeds bubbles. A shift to riskier loans during periods of euphoria automatically generates larger reserve allocations because riskier loans carry higher risk premiums.

Another advantage of TBR is that it applies to every transaction with a risk component, whether it is shown on the firm’s balance sheet or not. The principal responsibility of the regulator is to establish the risk component of every type of transaction. When credit default swaps appeared, for example, the TBR regulator would immediately have realized that the premium was 100 percent risk-based, and sellers would have been obliged to reserve 50 percent of their premium income.

Treasury’s toxic asset plan could cost $1 trillion

March 22, 2009

WASHINGTON – The Obama administration’s latest attempt to tackle the banking crisis and get loans flowing to families and businesses rely on a new government entity, the Public Investment Corp. to help purchase as much as $1 trillion in toxic assets on banks’ books.

The plan that Treasury Secretary Timothy Geithner intends to announce Monday aims to use the resources of the $700 billion bank bailout fund, the Federal Reserve and the Federal Deposit Insurance Corp.

The initiative will seek to entice private investors, including big hedge funds, to participate by offering billions of dollars in low-interest loans to finance the purchases and also sharing risks if the assets fall further in value.

When Geithner released the initial outlines of the administration’s overhaul of the bank rescue program on Feb. 10, the markets took a nosedive. The Dow Jones industrial average plunged by 380 points as investors expressed disappointment about a lack of details.

Christina Romer, head of the Council of Economic Advisers, said Sunday that it’s important for investors to know that the administration is bringing a full array of programs to confront the problem.

“I don’t think Wall Street is expecting the silver bullet,” she said on CNN’s “State of the Union.”

“This is one more piece. It’s a crucial piece to get these toxic assets off, but it is just part of it and there will be more to come,” she said.

Also in the coming week Geithner is expected to disclose the administration’s proposal to overhaul bank regulations to try to prevent a repeat of the financial crisis.

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March 22, 2009

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