“How would a Machinist say that?” Talking points for Obama on the financial crisis.

Posted September 23, 2008

During the early 1980s an odd combination of economic recession, bad career
planning, and good fortune pulled me out of my job making turbine blades at Westinghouse and landed me in the position of directing
education programs for about 200,000 west coast members of the
International Association of Machinists and Aerospace Workers.

I
trained union leaders how to organize voter registration drives,
bargain pensions, file grievances, or address airborne asbestos in the workplace, along with a
lot of other subjects. I often tested my ideas with Justin Ostro, Bill Wiegand or other IAM labor veterans. Whenever they noticed that a few years in a factory had not purged me of my college-kid formulations, they would ask a very useful question: “How would
a machinist say that, Marty?”

The request was for clarity not for smaller words or simpler ideas.
Machinists turn out to be as smart on average as professors or lawyers but much less tolerant of florid
language. They prefer to call a spade a damned shovel.

It is a question relevant to Barack Obama, who is struggling to offer an
economically coherent message concerning the financial crisis and will
be forced to do so in the debate this Friday, if not sooner. He is
facing the standard Democratic temptation to secure
“low information” swing voters with emotional appeals to
populist instincts.

He is struggling to connect emotionally to blue collar midwestern voters whose life experience
and political vocabulary is distant from his own. He needs to show
leadership and resolve in the face of a complex crisis without sounding
like a bonehead to people who understand financial markets or an egghead to those who don’t. He does not
feel free at this stage to ignore the preferences of other party
leaders – although he would in many cases be wise to do so.

He needs to be careful. For one thing, he does
not need the house of cards financial markets falling on his
statements. For another, sound economics is frequently bad politics.
For a third, the current debate manages to swerve between incoherence
and folly. It is not always easy or pleasant to join in. Finally, Ohio and Pennsylvania are too close for comfort. It is not a great time to screw up.

I offer Obama the following talking points in discussing a federal financial bail out. Summary: “Taxpayer
assistance must be tough, even-handed, and designed to give
birth to a new banking system, not just ease the headache of the old
one." Finally, he needs to note the tendency of folks to try and resolve unrelated problems at times like this and insist that we avoid distractions.

Dispense tough love evenly

If we are going to bail out lenders, we are going to bail out borrowers. But taxpayer help comes with tough love. If you are a bank or a homeowner that wants us to tax your neighbors to help you out, you will make a significant and painful contribution to the solution. There is no free lunch here.

This means that we will help banks but we will make it very expensive for them. The taxpayers will take toxic securities off of their books in exchange for a tradable, secured, preferred stock that will be senior to all other forms of shareholder capital. As the bank recovers, the government will resell its stock and get its money back – at a profit where possible. Shareholders will not benefit from government loans – in most cases they will be obliterated by them. Tough love (and shareholders will sign up for it).

We will do the same for homeowners. When we restructure your loan so that you can stay in your house, you will very likely owe less on your house than you do today, but your home equity will be wiped out just like a bank shareholders will see their equity wiped out. Your mortgage will be at lower, fixed interest rates and often on better terms than you have today, but you will pay your mortgage like everyone else or you will lose your home. Under this plan, you will not recover every dollar you put into your house – but you will not lose your home either. Again, tough love (although in this case most homeowners don’t have any equity left, so they too will sign up).

Banks that access the taxpayer funded trust will agree to new regulations, which I spell out below. Among these regulations is a ban on subprime lending – industry code for loans to people who cannot pay them back. If we wanted to transfer taxpayer dollars to poor people so that they can buy houses that they could not otherwise afford, we can just send them the money — no reason to use banks. There are, as it turns out, much smarter ways to help poor people with housing.

We will also cap adjustable rate mortgages and ban teaser rates, negative amortization, option ARMs, and other devices used to lure gullible borrowers into loans they cannot afford. We will not require more disclosures – nobody reads them anyway.

The result will be that owning a home will be more difficult — and fewer families will face the disruption of foreclosure as a result. Banning loans to poor people won’t make me or any other politician popular – but neither does taxing people to bail out banks from loans that they never should have made in the first place. This crisis is built on bad loans and we need to acknowledge that both lenders and borrowers and the government made serious mistakes. These loans should not have been made and in the future they won’t be.

Finally, we are going to pay for this ourselves. We are going to raise taxes on the rich, but the middle class tax cut I strongly favor will be smaller than I want and smaller than you want because I intend to keep my promise to make health care available to every American.

New rules for a new banking system.
There are six specific reforms that will address this crisis and prevent it from coming back.

Require banks to retain 5-10% of the loans that they originate for at least five years. If a bank can loan you money and then quickly resell the loan, they don’t really care whether you can pay it back or not because that loan is no longer their problem. The result is a whole lot of bad loans. But if we allow banks to only resell 90% of the loan, they have to care about the creditworthiness of their borrowers. They may make fewer loans because they will apply tighter credit standards and they will have less capital available – but we will all be better off.The five year limit is so that we don’t saddle banks with low interest loans in a high interest environment — exactly what led to the S&L crisis a few years back.

Tighten credit standards for conforming loans. When banks sell loans, they bundle them up and then slice them up into bonds. Or they get Fannie Mae or Freddie Mac to do this. Unless the loans are similar in credit risk, interest rate, and maturity you end up with a mess. Home loans need consistent capital requirements (no zero down loans). This is good economics, but tough politics because cheap mortgages and high housing prices are very popular with voters and with both parties.

Regulate credit derivatives. An unregulated $65 trillion credit default swap market “protecting” a highly regulated $10-12 trillion mortgage market does not make a lot of sense. Credit default swaps can be a form of insurance that allows firms to hedge and allocate risk efficiently. But because swaps can be sold, they can also be a way to speculate on the health of a company (if you think a company will default on an obligation, investors can sell the swaps short). This defeats the point of the insurance however — a buyer of a CDS may have to track down the holder of the swap that has been sold and resold (and in some cases sold to index funds). As a result, you have a market for a product whose underlying risks are not well understood by buyers or sellers. If derivatives are going to be traded like financial instruments they need to be regulated as securities, registered, standardized, and subject to capital sufficiency requirements. If not, they should be regulated as insurance with appropriate capital sufficiency and accounting oversight.

Better accounting standards. Part of the problem in the current crisis is so-called “mark-to-market” accounting, which requires that companies mark all of their assets to market each night so that investors know what the balance sheet looks like at the current moment.

Sounds like a great idea but in a world where information is communicated instantly, this requirement can drown a company in its own financial whirlpool. Accounting rules can set off a vicious cycle as companies mark down assets, get their ratings downgraded, which forces the sale of more assets on worse terms, which triggers a requirement that everyone downgrade their assets….and downward, downward, downward.

Federal standards are needed to address this and find a workable balance between revaluing assets and protecting investors from accounting-induced panic.

Sell off Fannie Mae and Freddie Mac. Frankly, we only pretended to privatize Fannie Mae and Freddie Mac back in 1968. The government wanted to borrow money for the Vietnam war, so we wanted the debt of these agencies off of the federal books. But we should have really sold them, instead of creating these huge companies that could never fail. We ended up with “heads the shareholders win, tails the taxpayers lose”. When times were good the company’s stock went up and management and shareholders made big money.When times were bad, everyone turned to Uncle Sugar.

Congress and the Administration should have been all over these guys when they started trading mortgage derivatives — but we didn’t. As a result, George Bush ends up nationalizing two public companies with tens of billions of dollars in revenue like he is channeling some pinko British Labour Prime Minister from the 1960s. We fired their management team and now we are going to have to sell off their loans.

Why did we do this? Because the alternatives were a lot worse.

Placing these institutions under government control helps keep people in their homes and protects the value of existing homes.

It increases lending, since banks know that Fannie and Freddie have money to purchase loans.

It increases access to home mortgages by qualified buyers because it improves liquidity in mortgage markets.

It lowers banks’ borrowing costs and helps consumers by reducing adjustable rate mortgage rates.

By stabilizing home prices, the government stabilizes the value of mortgage-backed securities and the credit default insurance that backs them.

But government does not need to be in the business of buying and selling home loans. Banks can do this and Fannie Mae and Freddie Mac should be phased out.

But we do need to be in the business of making sure that banks uphold appropriate credit standards, maintain an adequate capital base, and securitize these loans consistently and accurately so that investors know what they are investing in.

Create a super regulator, probably in the Treasury Department. We need to unify financial regulators into one agency. We do not need investment banks regulated separately from commercial banks (although as of today we no longer have traditional investment banks, so that problem may be solved). We do not need securities regulated separately from deposits and lending.

We should regulate mortgage brokers at the federal level because mortgage funds flow across state lines and when these guys originate bad loans, it is the federal not the state government that gets the call. States prefer to regulate mortgage brokers themselves for the simple reason that these guys are often hugely influential in local politics. They are big donors and no governor wants to see them regulated by someone else. But we need to do it anyway.

And merging regulators is always ugly, as Homeland Security illustrates. But we need to do it anyway.

The new regulator needs the authority to manage system risk, including the failure of large firms and other scenarios that affect multiple companies suddenly and simultaneously. The regulator needs to be well funded and able to move quickly, although Congress should create appropriate oversight.

Avoid Distractions
Getting these laws passed will not be easy. We need above all to focus on steps that matter and avoid becoming distracted by steps that don’t matter. There are several proposed reforms that make no sense and I will oppose them.

CEO pay. Wall Street pay is obnoxious, but this crisis would have happened even if the CEOs been working for free. I will support limits but I will not support delaying this essential legislation over this or other symbolic matters.

Restoring Glass-Steagall. The Glass-Steagall Act of 1933 mandated the separation of commercial banks, which take deposits, and investment banks, which issue securities. The legislation was a reaction to the stock market crash of 1929 and the banking collapse of 1933. The law was effectively repealed under the terms of bipartisan legislation signed by Bill Clinton (and potentially made irrelevant by the decision of the last major Wall Street banks to seek regulation as commercial banks so that they can take deposits). As a result, large commercial lenders like Citigroup can underwrite and trade mortgage-backed securities and collateralized debt obligations.

Clearly the granting of credit (lending) and the use of credit (investing) can generate conflicts of interest if undertaken by the same entity – and this was the original justification for the legislation. But most other countries manage this risk with internal controls and often by separating the functions in to separate organizations. The potential for conflict is not a reason to ban the activity entirely and economic research has tended to confirm the wisdom of repealing Glass-Steagall.

More to the point, commercial banks are not the big problem right now – indeed the diversified financial institutions created by the repeal of Glass-Steagall are the healthy ones (Bank of America bought Merrill Lynch; Barclays is taking the healthy parts of Lehman Brothers). Since investment banks did not create collateralized debt obligations until 1987, it is hard to see how anything in Glass Steagall could possibly regulate this activity or impose capital requirements on participants in trading these securities.

Bans on short selling. In every financial crisis, demagogues attack short-sellers. The current ban on short selling has more to do with the presidential campaign than it does with the underlying cause of the credit markets seizing up – something that nobody has blamed on short selling.

John McCain has unfortunately chosen to join this chorus, going so far as to demand the resignation of SEC Chairman Chris Cox over this issue. A guy like McCain sees people who profit financially from a crisis that impoverishes others and decides that those people are evil. As a result, the US and British governments have temporarily banned shorting financial stocks.

But take a deep breath and recall what short-sellers do. Normally you buy a security with a goal of selling it at a higher price. Those who are long in a stock buy low in order to sell high. Short sellers engage in the counterintuitive practice of selling high in order to buy low. They sell a security they don’t own with a promise to buy it back, hopefully at a lower price. People who trade long are bulls – they expect prices to go up. People who sell short are bears – they expect prices to go down.

A critical difference between long and short selling is downside risk. If you buy a stock for $100, your gains are theoretically infinite because there is no limit to how high the price of the stock can go. And the most you can lose is $100. But If you sell a $100 stock short hoping that the price falls, the most you can make is $100 but your potential losses are infinite, since if the price soars, you are obligated to pay the difference between the current price and whatever you sold it for. As traders who avoid short positions like to say: “markets can stay stupid longer than you can stay solvent”.

The protestations of CEOs notwithstanding, short selling cannot hurt an actively traded company. Short-selling does not force a stock price down. If a company is valuable, there will be investors who buy as the price drops. If investors don’t buy, then investors found better opportunities and the company got repriced. A company that is sure that it is worth more than its trading price can, after all, buy back its own shares and resell them when the price goes back up. Companies can always trade their stocks long – just never short.

Critics of short sellers assert that they manipulate market information by spreading bad news or profit from those who do. The problem of market manipulation has nothing to do with short selling – after all, you can buy a stock, spread a rumor that a company is about to release record earnings, and sell when the stock rises just as easily as you can short a stock, spread a rumor of a disaster that has befallen a company, and buy when the stock tanks. Manipulating stock prices as an insider or an outsider is illegal and should be, but it has nothing to do with short-selling.

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OK, I got a little wonky at the end there (this journeyman machinist got an MBA — not always a winning combination). But Obama could do a lot worse. And sadly, he has.