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April 26, 2010

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Paul Krugman: Berating the Raters

Posted: 26 Apr 2010 01:17 AM PDT

Paul Krugman continues the discussion on the problems with the ratings agencies, and the failure of congress to do anything about it:

Berating the Raters, by Paul Krugman, Commentary, NY Times: Let's hear it for the Senate's Permanent Subcommittee on Investigations. Its work on the financial crisis is increasingly looking like the 21st-century version of the Pecora hearings, which helped usher in New Deal-era financial regulation. In the past few days scandalous Wall Street e-mail messages released by the subcommittee have made headlines.
That's the good news. The bad news is that most of the headlines were about the wrong e-mails. When Goldman Sachs employees bragged about the money they had made by shorting the housing market, it was ugly, but that didn't amount to wrongdoing.
No, the e-mail messages you should be focusing on are the ones from employees at the credit rating agencies, which bestowed AAA ratings on hundreds of billions of dollars' worth of dubious assets, nearly all of which have since turned out to be toxic waste. And no, that's not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.
What those e-mails reveal is a deeply corrupt system ... that financial reform, as currently proposed, wouldn't fix.
The rating agencies ... play a central role in our whole financial system, especially for institutional investors like pension funds, which would buy your bonds if and only if they received that coveted AAA rating.
It was a system that looked dignified and respectable on the surface. Yet it produced huge conflicts of interest. Issuers of ... securities ... could choose among several rating agencies. So they could direct their business to whichever agency was most likely to give a favorable verdict, and threaten to pull business from an agency that tried too hard to do its job. It's all too obvious, in retrospect, how this could have corrupted the process.
And it did. The Senate subcommittee has focused its investigations on the two biggest credit rating agencies, Moody's and Standard & Poor's; what it has found confirms our worst suspicions. In one e-mail message, an S.& P. employee explains that a meeting is necessary to "discuss adjusting criteria" for assessing housing-backed securities "because of the ongoing threat of losing deals." Another message complains of having to use resources "to massage the sub-prime and alt-A numbers to preserve market share." Clearly, the rating agencies skewed their assessments to please their clients.
These skewed assessments, in turn, helped the financial system take on far more risk than it could safely handle. ...
So what can be done to keep it from happening again?
The bill now before the Senate tries to do something..., but all in all it's pretty weak... The only provision that might have teeth is one that would make it easier to sue rating agencies if they engaged in "knowing or reckless failure" to do the right thing. But that surely isn't enough...
What we really need is a fundamental change in the raters' incentives..., something ... to end the fundamentally corrupt nature of the the issuer-pays system.
An example of what might work is a proposal by Matthew Richardson and Lawrence White of New York University ... in which firms issuing bonds continue paying rating agencies to assess those bonds — but ... the Securities and Exchange Commission, not the issuing firm, determines which rating agency gets the business.
I'm not wedded to that particular proposal. But doing nothing isn't an option. It's comforting to pretend that the financial crisis was caused by nothing more than honest errors. But it wasn't; it was, in large part, the result of a corrupt system. And the rating agencies were a big part of that corruption.

Taxes on the Financial Sector Should be "Fair and Substantial"

Posted: 26 Apr 2010 12:51 AM PDT

Carlo Cottarelli, Director of the IMF's Fiscal Affairs Department, explains the thinking behind the IMF's call for taxes on the financial sector (detailed in a leaked report):

Fair and Substantial—Taxing the Financial Sector, by Carlo Cottarelli: We knew we were in for a tough time when the ... Group of Twenty (G-20) asked the IMF to give them our views, at their summit coming up in June 2010, on  "… the ... options countries have ... as to how the financial sector could make a fair and substantial contribution toward paying for ... government interventions to repair the banking system." ...
Last week the IMF gave an interim report to the G-20 finance ministers... That report is confidential, but—you may have noticed—has still managed to attract a lot of attention.  So let me set out how our thinking on this stands. ...
What is to be done?
The challenge is to ensure that financial institutions bear the direct fiscal costs that any future failures or crises will impose—and maybe somewhat more, given all the other costs that bank failure can impose on the economy. We also need to make these events both less likely to happen and less costly when they do. We think two types of tax can play a role.
A 'Financial Stability Contribution'—I come to bury Caesar, not to bail him out
One reason the crisis was such a painful mess was that many governments did not have the tools to wind down failing institutions in a quick and orderly manner. ... Governments lacked a way to 'resolve' ... large failing institutions.
Resolution means equity holders would be wiped out, management replaced, and unsecured creditors take a loss—a 'haircut'—on their claims. All this should be nasty enough for owners and managers to reduce any problems of 'moral hazard'... But most countries still don't have such a mechanism. Financial stability requires creating them.
So where does the idea of a contribution come in? Resolution requires upfront cash, to reduce uncertainty for creditors (and the creditors' creditors…) by quickly giving some value to their claims. And the industry should pay for this... This is what we call a Financial Stability Contribution (FSC).
It would ensure that the industry does indeed pay a reasonable chunk of these resolution costs before a crisis occurs, with this amount topped up, if needed, by 'ex post' charges after disaster strikes (much as the Financial Crisis Responsibility fee proposed in the United States aims to recoup some of the costs of public support). ...
A 'Financial Activities Tax'
A FAT is just a tax on the sum of the profits and remuneration paid by financial institutions. That sounds simple, and, in essence, it is. But why an extra tax on financial institutions? Here, I'm afraid, things get a bit nerdy. So brace up for what is coming.
Profits plus all remuneration is value added. So a tax of this kind would be a kind of Value-Added Tax or VAT. ... This means that a FAT of this kind could ... help offset a tendency for the financial sector, purely for tax reasons, to be too large—or too fat.
Now suppose that the base included only remuneration above some high level, and only profits above a 'normal' rate of return. Then the base of the FAT may not be a bad proxy for taxes on 'rents'—return in excess of competitive levels—earned in the sector. Some might find taxing that excess fair. ... Taxing away some of these high returns in good times may help correct for any tendency to excessive risk-taking implied by financial institutions not attaching enough weight to outcomes in bad times... 
What about a financial transactions tax?
 We also looked at the idea of a general financial transactions tax (FTT)—the last few months have left us in no doubt as to the seriousness of the public support this enjoys. This would be a tax paid every time a share, bond, or other financial instrument is bought or sold, and/or whenever foreign currency is bought or sold.
Our work is not yet complete—this is an interim report, remember—but, while some forms of FTT may be feasible (indeed most G-20 countries already tax some financial transactions),... the ... FTT is not  focused on reducing systemic risk and it isn't effective at taxing rents in the financial sector—much of the burden may well fall on ordinary consumers.
Moreover, the financial services industry is very good at devising schemes to get around such a tax and (this is also true, to be fair, of the FSC and FAT, but we suspect to a lesser extent). One way to think about the comparison is that just as a FAT is like a VAT, an FTT is like a turnover tax—and most countries have long found that the VAT is better at raising revenue: in the jargon, more efficient. ...
What we gave to G-20 ministers was an interim report, and we will be working more on this... We ... hope to contribute to the debate on what really matters in all this: how to reduce the risk, and costliness, of future financial failures.

Some form of a Financial Stability Contribution might make it through Congress, though Republicans are using misrepresentation and other means to try to prevent the extension of resolution authority to the shadow banking system (that might make sense politically, though that's not clear, but it makes no sense at all from an economic standpoint). As for a FAT tax (or a FTT), it's a good idea that has little if any chance of getting through a Congress whose reelection chances depend upon donations from the financial industry.

links for 2010-04-25

Posted: 25 Apr 2010 11:03 PM PDT

On the Road Again...

Posted: 25 Apr 2010 08:46 AM PDT

Traveling here today. Comments are open...

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