All About Picking Losers as Winners: Interview With Bob Feinberg

Today we ran an interview with Robert Feinberg, who is one of Washington’s veteran observers of the financial industry.  We also commented on the latest outburst by Treasury Secretary Tim Geithner.   Enjoy.  Chris

The Institutional Risk Analyst

August  5, 2009

On Friday we described to subscribers of The IRA Advisory Service why we downgraded our outlook on US Bancorp (NYSE:USB) from “positive” to “neutral,” and reaffirmed our “positive” outlook on Cullen/Frost Bankers (NYSE:CFR).  For more information about this report or our coverage universe, please contact us:

Today we are in Samoset, Maine, at the meeting of the National Business Economic Issues Council (NBEIC). Despite the interesting presentations and views expressed at NBEIC, we could not help but take a moment to comment on the regulaltory reform process since it seems that the Secretary of the Treasury forgot to take his Xanax last week.

The WSJ reports that “Timothy Geithner blasted top U.S. financial regulators in an expletive-laced critique last Friday as frustration grows over the Obama administration’s faltering plan to overhaul U.S. financial regulation.” Among those gathered in the Treasury conference room were Federal Reserve Chairman Ben Bernanke, Securities and Exchange Commission Chairman Mary Schapiro and Federal Deposit Insurance Corp. Chairman Sheila Bair.  Friday’s roughly hour long meeting was described as unusual, not only because of Mr. Geithner’s repeated use of obscenities, but because of the aggressive posture he took with officials from federal agencies that are, by law, considered independent of the White House.

Secretary Geithner reportedly reminded attendees that the Obama Administration and Congress set policy, not the regulatory agencies. Presumably the target of Geithner’s ire was FDIC Chairman Bair and SEC Chairman Schapiro, who expressed a collective unwillingness to yield power over to Fed Chairman Ben Bernanke.  Chairman Bernanke, of note, seems to be running for reappointment based on the FOMC’s incredible, single-digit unemployment projections for 2010.

Secretary Geithner is correct that the Congress makes policy.  The executive branch only proposes and implements, right?  Until the Congress actually votes and the President signs the legislation, though, there is no new policy.   Given the complete lack of leadership from the White House on regulatory reform, the agency heads can probably be forgiven for focusing their attention on the Congress and not the wants and needs of Secretary Geithner, who we still believe is not long for this political world. When the next round of good news comes out of American International Group (NYSE:AIG), we expect that Secretary Geithner’s inability to sell his home in New York may cease to be a problem.

The fact is, there is no great push from either the public nor the Congress for regulatory reform, no more than there is a great groundswell of public demand for health care reform.  In both cases, the Obama Administration is playing political poker with a very weak hand.  It looks to us like both regulatory reform and health care, if they get them done at all, will look nothing like the proposals emanating from the White House.

For example, we hear that the Obama Administration’s new proposal for regulating OTC derivatives (it will cover ALL OTC derivatives, not just credit default swaps or “CDS”, including interest rate swaps).  Our sources expect the headline language will represent very real regulation of OTC and may negatively effect the larger dealer banks.  We hear that the proposal will ensure that the system evens the playing filed between the dealers and end-users in terms of economics, access and information.

After its release there will be dealer friendly parties who will try and water it down on behalf of Goldman Sachs (NYES:GS) and JPMorgan (NYSE:JPM). But it is unclear how much success they will have given the populist outrage at the dealer community and given Obama poll numbers that are slipping in recognition of how little has been achieved by way of in reigning in the industry.  Our sources say that there will be two defined product categories in the new proposal — standardized and non-standardized:

Standardized – All products that have or can go through the SEC or CFTC approval process and be listed on a CPP or exchange.

Non-standardized – If a product is not able to be listed it should have two-way margining by dealer and end-user. This should be done in a way that does not advantage one party. We do not believe the margin requirements have been set in the language and expect they will be determined by the regulators. We hear that the regulators are likely to set them in a way that creates incentives to standardize, but allows “market innovation.” Note that the three-page ‘white paper on OTC reform issued by Rep. Barney Frank (D-MA) and Colin Peterson (D-MN) did retain the ban on naked CDS exposures, but we expect it did so as a bargaining chip.

To gain some perspective on goings on in Washington, we return to our old friend Robert Feinberg, who reports on the financial services industry for his private clients. If you did not read our March 2008 interview with Bob, when he predicted much of the financial crisis and in particular Washington’s embrace of the government sponsored entity or “GSE” as the preferred business model, please click this link:  “GSE Nation: Interview with Robert Feinberg.”

The IRA: Thanks for making time to talk to us this week. You are usually sitting in a hearing room somewhere, so you are not an easy man to find.

Feinberg: That’s on purpose. To say that I don’t like mobile devices is an understatement. Eventually these things will be implanted in our brains. In the meantime they are just destroying our brains.

The IRA: We look at them as a necessary vice, but always with a view to letting the battery die on weekends.

Feinberg:  That’s why they’re called de-vices.

The IRA:  So give us your view of the world after the first however many days of Barack Obama in the White House.

Feinberg: I see Obama as very reminiscent of both JFK and Jimmy Carter. Neither was prepared to do the heavy legislative lifting that we see going on now. By the time that JFK went to Dallas, his calls were no longer being returned and there were problems in the party — not unlike what we see developing now. He was someone who really did not have a lot of national experience, having served only briefly in the Senate. The relationship to Carter is that Obama basically has experience at the state and local levels, which is reflected in his preference for town hall venues. The last election featured someone with little experience, Obama, versus someone with a lifetime of experience, John McCain (R-AZ), from which he either hasn’t learned much. Maybe a better way to say it is that we don’t know what McCain learnt.

The IRA: Yes Obama seems to be operating on a continuous campaign format. Reminds us of Vicente Fox in Mexico. Great campaigner, lousy manager.

Feinberg: Bill Clinton perfected the continuous campaign, but consider the Carter metaphor further. His legislative operation never got off the ground at all, ditto Obama so far. The Democrat leadership is driving the process. This is not to say that the Republicans will be able to take advantage of this. I think it is possible that Obama could face a self-financed independent candidate in 2012 a la Mike Bloomberg with the Republicans finishing third.

The IRA: Isn’t it remarkable that the legacy of the Bush family has been to now twice leave the GOP in complete disarray? Our friend and mentor Noel Parmentel wrote in The Nation in 1993 that the GOP is “the stupidest party,” this when Ross Perot was preparing to pluck the prize from Bob Dole. He actually borrowed the phrase from John Stuart Mill. If you consider the choice of McCain-Palin in the context of earlier Republican tickets like Dole, ending up with eight years of GWB makes some sense. So there is no sign that the Republican disintegration is ending? Do you see a leveraged buyout of the GOP by an outsider in the image of Perot as a possibility?

Feinberg: I’ve seen that quote attributed to Disraeli. Or maybe it was Yogi Berra. It’s a shame so many of the best quotes were taken before our time. It seems that Mill has a quote for all occasions. My favorite is a quote I saw on a poster opposing a third term for FDR. It went something like, “A people may desire Freedom. But if they can be induced to lay their Liberty at the feet of even a Great Man, they will not long enjoy it.” However, I’ve never been able to find the quote in such a pithy form.

No buyout is in prospect; more like a sellout. Not that the Bush People cared about the party, any more than Ike did, or Nixon did, or Ford did. My favorite slogan from the Dole campaign was “Dole IS 96.” The Bushes hijacked the party and turned it into a family enterprise. They had the opportunity to do this because Reagan, apparently at the behest of Richard Allen, picked GHW Bush after negotiations for a co-presidency with Ford spectacularly, and fortunately, fell through. The GOP has been disintegrating for a while, and it is continuing. If you look at what they’re doing on a day-to-day basis, as I do, you see that Republicans mouth the talking points of the bankers and health insurers. After a previous episode of the Financial Crisis, the Republicans opposed assessing deposit insurance premiums because the industry didn’t want them.  They said higher premiums would reduce the availability of credit.

The IRA:  Nothing like a bank solvency crisis to boost lending.

Feinberg:  I had a chance to talk to Chuck Schumer (D-NY) at one of his book presentations last Fall and pointed out that the Democrats won’t have the Republicans to blame anymore. You see a reflexive tendency by Obama and the Democrats, though not necessarily Schumer, to blame the Republicans, to use them as a foil. Schumer told me that he knew that the Democrats would have a great opportunity, but he worried that they would not take full advantage of it.  Now we seem to be in that circumstance.  Today, the Republicans are a non-factor. Historically they have played the role of the Washington Generals to the Democrats Harlem Globetrotters.

The IRA: It sounds strangely like the political devolution visible in nations of the Americas like Venezuela, where the incumbent derechista tendency eventually collapses and flees the country, leaving the authoritarian left with a monopoly. But we still prefer Italy under Berlusconi for political metaphors about a future America. What happens to the Democrats in this scenario? Do they eventually split?

Feinberg:  My model is Argentina.  Under my scenario, Hillary was going to play Evita. The Democrats already have two parties within the greater whole, the so-called progressives and the Wall Street wing.  Eventually the progessives must rebel or just go away.  A year ago I ran into Bill Grieder and suggested that the Democrats were really going to owe the Wall Street crowd because Schumer and Ramm Emanuel had put together this tremendous victory in 2006 that presaged 2008 using Wall Street money.   He refused to acknowledge that, so already the line was being drawn.  But now look at how the progressives are complaining about the “conservative” tendencies of the Obama Administration and their ties to Wall Street.

The IRA:  So given that Wall Street owns Barack Obama, what happens with regulatory reform? You have been telling us that the reform proposal was DOA, but that something would or could come out of the process given unforeseen externalities.   Is that still the case?

Feinberg: There is something to be said about this. A while back, I realized that I had to come up with a new way of saying that the reform legislation was dead-on-arrival. The key from a journalistic standpoint is to be able to do that when you need to. So I came up with the concept of a Zombie proposal, like a Zombie bank. The reform staggers around in a state of essential death, one that can come back to life at any time, which is what happened with Sarbanes-Oxley in 2002.  But there could be some kind of a disaster anytime from tomorrow to a year from now that will create a mad dash to get something into law.  The odds of that occurring are pretty good. So people should pay attention to what is going on here as arguments are made and provisions are drafted. Interest groups are gaining and losing ground as we speak.

The IRA: So does another surprise like needing to inject tens of billions more public funds into AIG, for example, provide the catalyst for a stampede?

Feinberg: Some type of systemic failure or the failure of a Treasury bond auction will suffice.  By the way, you seem to have thoroughly confused everyone on Capitol Hill by saying in your testimony that we can’t measure Systemic Risk. Now everyone is saying that. The other day they had a whole panel, and none of them could define it beyond an institution capable of bringing down the system through its misadventures.  Years ago, an anthropology professor at Penn named Anthony F. C. Wallace coined the term Disaster-Prone Organization in his book St Clair. He was talking about the coal industry.

The IRA: Ha! Well, objectively speaking, Systemic Risk is like fear. No way to describe or measure that with objective means. What we have said consistently is that if you increase transparency and lower “hidden” leverage, Systemic Risk goes away. Alan Blinder and others are wrong to say that there is no choice save giving the Fed more power when it comes to Systemic Risk. The clear choice is to compel the Fed to do its job as regulator, lessen leverage and increase transparency, then Systemic Risk will disappear.

Feinberg: “We have nothing to fear but Systemic Risk itself.” Not very catchy.  It’s a classic case of regulators who failed demanding more power. The SEC did that after the mutual fund scandals, saying that if they had authority over hedge funds, they could see around corners and identify problems. A classic case is when W said we missed 9/11 because we didn’t have a Department of Homeland Security.

The IRA: Well, people forget that risk management is about looking ahead; to identify risks and then implement policies to avoid these risks.  Governments and banks are too worried about the present to be good risk managers.

Feinberg:  We certainly are not doing anything about risk at present.  Instead, the game is to Restore Confidence in the people and policies that haven’t worked for the last forty years or so. Once confidence is restored, the stage is set for the next episode of the crisis.  Our friend Alex Pollock is fond is saying, “A confident investor is a stupid investor.” Henry Kaufman dates the beginning of this crisis to 1966. It’s pretty clear watching the financial press that nobody is paying the slightest attention to risk reduction in the markets. On the contrary, with short-term rates so low thanks to the Fed, investors have no choice but to reach for risk. I’m reminded of the headline in The Onion: “American People Demand New Bubble To Invest In.”

Here’s one sleeper issue:  Senator John Warner (D-VA) has been saying that any systemic solution must be pre-funded like SIPC and previous industry self-insurance efforts. It has also been suggested by others that SIPC needs to be beefed up with some sort of FDIC-like examination function. But obviously, if the markets believed that the industry would have to pay its way, we would never have seen the huge rally in banks stocks that occurred from the end of the first quarter until today. Even as we talk about Systemic Risk, the Fed and other authorities are working to create a new bubble in securities markets fueled with public money. The confidence of the markets in this arrangement is badly misplaced, in my view, and is simply another case of Irrational Exuberance, courtesy of the authorities.  Whenever the Fed decides to slip the Yield Curve again, they create a panic to get into financials. It actually damages the economy, because it distorts incentives and keeps the Zombie banks pumped up on steroids when they need to be shrunk to maybe a fraction of their bloated size. A host on CNBC’s “Squawk Box” observed recently that banks really don’t do very much, and Greenspan once told Senate Banking that some people would say banks exist only to feed off of the Yield Curve.  This strategy is described as, “Borrow short, buy anything.” One of the Lessons Learned from the S&L crisis was supposed to be not to do this, but no less a personage than Bill Isaac told an SEC roundtable that this is what banks do. My way of formulating this is that we can have the Zombie banks, or we can have the economy, but we can’t have both.

The IRA: Yes, and all of this even as the fundamentals of the industry are under more stress than at any time in half a century. As we told subscribers to the IRA Advisory Service last week, maybe financials will have a different tenor when Capitol One Financial (NYSE:COF) is reporting double digit charge-offs and some of the large money centers are in high single digits. Do you sense that any of the Democrats other than say Schumer understand how fragile is the condition of the credit standing of the US? We watch the Obama Administration proposing to increase spending on health care and to increase the government’s funding needs in the debt markets, thus the question.

Feinberg: Among the members there is not much discussion of anything besides stimulus measures. I say that what they’re trying to do is to “simulate” the economy.  This is what Larry Kudlow proposed at the last meeting of CMRE we were allowed to attend. He wanted to steepen the Yield Curve to help re-elect W by restoring pricing power, so that the economy would look healthy. It was another version of putting lipstick on a pig. One difficulty for the Democrats is that they are dealing with an honest regulator in the Congressional Budget Office. Alice Rivlin created an ethic at that agency of putting out honest numbers. The CBO has said that the Obama reforms do not change the cost curve in the health care really.

Likewise, the Obama regulatory reforms for financial services do not really change anything in the industry.  Look at how we are not dealing with the GSEs like Fannie Mae and Freddie Mac, a circumstance we warned about back in 2004 or 2005.  Congress created a World Class Regulator who certified the GSEs as Well Capitalized. The result is a financial sinkhole that will require hundreds of billions of dollars in public subsidies for years. I have come up with a formula that links the cost of these bailouts with the decline in asset values. I so warned the Reagan transition team, keep in mind.

Since then, we have been through four different episodes of crisis. Each time, the cost to the taxpayer goes up by an order of magnitude and the value of collateral goes down to a similar extent. Now we are into the range of $10-20 trillion in public claims as opposed to the billions we talked about under as Reagan, Don Regan and our friend Peter Wallison at AEI were taking office. Now a good deal of the collateral is worthless. We achieved this in just two decades. In fact, Special Treasury Department Inspector General to oversee the Troubled Assets Relief Program, Neil Barofsky, has even jumped ahead of IRA and our friend Nouriel Roubini in terms of estimating the maximum cost of this cycle.

The IRA: The numbers we are seeing from Charlie Biderman and other surveys on delinquencies in residential and commercial real estate are in low double digits and rising, while the banks are showing aggregate NPLs for the industry of 2.5%.  Eventually these two lines must cross.  First with the GSEs and now the banks, the regulators are employing forbearance with respect to recognizing bank losses and this will further reduce liquidity and the ability of banks to lend.  By forebearing on closing Zombie banks, we are turning the banking industry into REITs.

Feinberg:  That will suit the housing industry just fine.  Another interesting data point came from Joe Mason the other day, when he pointed out that housing is still being built in many cases in competition with collateral that is coming onto the market.  He said this is happening in places two and a half hours drive from major cities that are remote from public transportation and other services where no one would want to live.

The IRA: We have reported this.  The Democrats would rather subsidize homebuilders than allow the real estate market to find a bottom more quickly.

Feinberg: That’s why we call it the Housing Industrial Complex. The realtors, the suppliers, the builders represent a big slice of Americana that commands immediate and constant response from both parties. Also, people who work in various segments of the industry have populated Congress and state legislatures to an extent that hasn’t been noticed or reported. A realtor, for example, is perfectly situated to run for Congress.  All she has to do is change the legend on her lawn signs from Buy to Vote.

The IRA: Well, how do you think the Democrats will respond when home prices fall another 10-20% nationally, in part because states such as CA are subsidizing homebuilders who are adding units to a saturated, liquidation market?  Between the shadow inventory of unsold homes and the mounting foreclosure backlog, there is no place for prices to go but lower in many markets.

Feinberg: We can answer that because it is already happening. The Congress is assembling a number of patchwork proposals to prop up the housing industry. I have not seen the letter yet but it was placed in a hearing record last week by the ranking Republican on the House Financial Services Committee, Rep. Spencer Bachus (R-AL). The effort could include things like accounting rules changes for so-called legacy assets, extending the period banks can hold REO, and jawboning the government to buy some of this toxic waste. Notice that Barney Frank (D-MA) and Gary G. Miller (R-CA), a former real estate developer, both took credit for taking measures early in the year to help housing and the banks by loosening the Mark to Market rules, so we are getting ready to do that again.  There will be various efforts to buy bad assets from the banks above market via TALF, etc.

The IRA: The TALF has hardly been a success. And the banks are giving back their TARP money to qualify for bonus season – this so that they can become political targets next year. You really have to be impressed with the political acumen of the largest banks, especially Goldman Sachs (NYSE:GS).

Feinberg: Sen. Bob Corker (R-TN) has accused the administration of perpetually extending the TARP, so that its bureaucrats can prop up Zombie banks indefinitely. This would enable the Obama Administration to pick friendly winners and losers among the financials. Actually what they are doing is picking losers as winners. The cost of this will grow yet again if Joe Mason, Susan Wachter, Josh Rosner, you folks at IRA and others are right about the magnitude of the next wave of foreclosures due to schedules resets of option ARMs and mortgages hitting their maximum permissible LTV ratios.  Don’t worry, though. If this causes the market to crater, my prediction is that the TARP or TALF will start buying stocks before next November.

The IRA: So what happens with health care reform?

Feinberg: There is a remarkable commonality between financial regulatory reform and health care because both are languishing. The cynic in me – and I am never cynical enough – is still having a hard time coming to terms with the policy of combining Zombie banks and investment firms into ever larger entities. During the S&L crisis these were known as “phoenixes.”  We were told that “It Would Never Happen Again.”  At that time, I predicted it would happen.  On the day Hank Paulson was appointed Treasury Secretary, I said there’s a problem at Goldman, and we don’t know what it is, but we’re going to find out. Turns out it was AIG.

The cynical way to look at Washington is as a parallel universe after the Orwellian model.  We can also use such examples to predict the form of future crises. The Obama Administration has picked up the mantra of the US banking industry being the “backbone of the economy,” but in reality I think it is the inflamed appendix that threatens the life of the patient. We have been told that these Zombies are healthy and will be restored to their former glory. If this is the case, why is it that the largest banks are the worst run and that they failed to build capital during the longest expansion the economy has ever seen?

The IRA: We’ll have to ask Chairman Bernanke that next time we speak to him.  Thanks Bob.

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