Wednesday, September 30, 2009

What a Statistician's Investigative Instincts Can Tell Us About Modelling Risk

Man, James Kwak wasn't kidding about a neat little time waster ... he laid a link honeypot over at Baseline Scenario that led to here, and I chased it, and I must have blown ... oh, God all the minutes. And I really had stuff to do today. Drat.

At the heart of "Are Oklahoma Students Really This Dumb? Or Is Strategic Vision Really This Stupid?" lies the question: Did a pollster finesse a little data to please its conservative client?

Here's what's going on (and please do chase the link, but be forewarned -- it's a time eater): Nate Silver, author of (the number of electors in that quaint anachronism we call an electoral college), smelled a rat when an outfit called Strategic Vision released the results of another one of those "you won't believe how stupid Americans are" polls. It showed Oklahoma high school students were pretty close to drop-dead dumb (only 23% reportedly could identify George Washington as the first president). Not a single one of 1,000 students could even correctly answer as many as eight of ten basic questions, mainly civics stuff (example: "We elect a U.S. senator for how many years?").

The poll was commissioned by what Silver describes as a conservative-leaning Oklahoma group. Obviously, the results supply ammunition to those who decry the parlous state of public schools. Which, come to think of it, pretty well describes a significant chunk of right wingers. Hmm, Silver thought, something stinks here. After all, it's kind of hard to fathom that not one Oklahoma high schooler out of 1,000 happened to be one of those annoying Poindexter types who's always got his hand up in class and seems to blurt out the answer to everything. What are the odds?

Exactly. I enjoyed Silver's statistical analysis, though found it a little hard to digest on a first scan. Judging by the comments (and he got a slew!), I think his argument sailed over a lot of heads. But there's a really neat statistical lesson embedded in the detective work he did, so I'm going to revisit it here.

Silver, after sensing something fishy, decided to try to square two bits of information. (1) The results of the ten questions that pollsters claimed to have asked. For instance, 28% of the students got question number 1 right, 26% question number 2, 27% question number 3, etc. (2) The breakdown of how many students answered how many questions correctly. For instance, 24.6% got two questions right, but only 8% managed to get five. And so on.

You may wonder, what is there to "square" here? Well, we have a distribution issue at hand that turns out to be quite fascinating. Namely, how are all these correct answers distributed among the 1,000 students? To illustrate why this matters, look at the first two questions alone. The first was answered correctly by 280 of 1,000 students (28%), the second by 260 (26%). Now consider two radically different scenarios:

1. It's Harrison Bergeron High School, and all students have exactly the same chance of getting any question right or wrong. So that means 280 got the first question right, and 26 percent (73 people) of that group also knew the answer to the second question. So, based on my all-students-are-equal assumption, the distribution of correct answers now looks like:
0 correct=540 (54%)
1 correct=467 (46.7%)
2 correct=73 (7.3%)

2. For the sake of making a point, let's say these 1,000 students are wildly disparate. There's a group of 200 pretty smart students and 800 not-so-bright ones. Let's say the 200 smart kids got both questions right, but nobody in the not-so-bright group did. In this case the distribution looks like:
0 correct: 660 (66%)
1 correct: 140 (14%)
2 correct: 200 (20%)

Notice that the breakdowns are hugely different. Of course I've exaggerated the groups to make a point. But what's more realistic? In any group of 1,000 people, we'd expect to find the smart, the not-so-smart, the kind-of-dumb: a variety of intelligences, in other words. So what Silver does is run a hypothetical distribution of data points representing how each student did, based on two different populations: (1) the unreal population I created in example number one (2) a normal population (his example is much more normal than mine above) of kids who are smart and dumb and everything in between.

And he makes a real "ah hah!" discovery: the distribution for the "unreal" population produces a cluster of points almost identical to what Strategic Vision found. Which makes you wonder if these are, well, really real kids and a real poll ... or someone in a back room just whipped up some data.

Great statistical analysis.

The relevancy to finance: Silver's analysis can be viewed in the context of correlation: Is it more likely you'll get question two correct if number one was? The answer to that should be clear: Of course it is. Smarter students are more likely to get both correct; kids who slept through half of grade school and flunked every other course have a greater chance of getting neither right. There is a positive, meaningful correlation.

Before this financial crisis, there were a lot of busy modelers behind the scenes who thought they had managed to evaporate risk into the mist. One element of their flawed models now worth revisiting: the degree to which variables are correlated, in ways that we aren't immediately aware of. Is the chance of A happening truly independent of the chance of B, or is there some kind of subtle multiplier effect resonating through the equation?

As Buffett famously said, "Beware of geeks bearing formulas." I'm very suspicious of clean models that attempt to predict complex systems. I think there are a lot of interactions that aren't understood well at all, especially in this world of modern finance.

Sunday, September 27, 2009

Still Not Convinced the Fed Shouldn't be the Systemic Risk Regulator?

I argued against the Fed taking such a role in this blog entry earlier this month. Among my five points was this:
The Fed doesn't have the regulatory chops.

And what do you know? The Washington Post now does a detailed autopsy on how the Fed failed to rein in the mortgage lenders who abused subprime borrowers: As Subprime Lending Crisis Unfolded, Watchdog Fed Didn't Bother Barking. Consumer finance companies sprang up in an unregulated space, and as they boomed, established banking companies jumped in to create their own mortgage-lending units and grab a chunk of the profits. Throughout this period, the Fed decided not to get involved.

The takeaway points: (1) The Fed didn't just regulate lightly. It turned its back on this sector altogether, while these predatory lenders grew like weeds. (2) The Fed was being warned about these lenders as early as 1998, about a decade before everything fell apart. (3) When the Fed declined to supervise them, that left a vacuum, because the Fed alone was in a position to handle the job, according to a 1999 report by the General Accounting Office. (4) Possible reasons for the Fed's indifference: under Greenspan it didn't believe much in regulation anyway (surprise, surprise!) and had an "affinity" for the financial industry (5) The article suggests the Fed is a place full of navel gazers who like to deep-think about the economy and not muck around with anecdotal details. As the Post tells us:
The Fed also minimized repeated warnings about mortgage lending abuses in part because it was an institution dominated by big-picture economists focused on the health of the broader economy rather than the problems faced by individual borrowers.
This brings me back to a simple yet common-sense point: The Fed is full of Phd academic economists, from what I can tell. By temperament, these kinds of guys are NOT good regulators. Imagine putting the Princeton economics department in squad cars and having them patrol the city for crime. First night, they'd all be gathered around a stoplight, sipping lattes and debating whether the length of the interval between green and red light signals encouraged risk-taking behaviors and what kind of model could best capture the expected increase in traffic violations.

Saturday, September 26, 2009

Toward a New Philosophy of Regulation

In the early stages of the financial crisis, I recall having a conversation with a Citigroup banker. I was waxing indignant about the failure of regulation leading up to the collapse. Her shrugging response: It's a losing game for regulators anyway; Wall Street will always stay a step ahead of them.

It's not that I completely disagree. Regulation is difficult. Take for instance the I.Q.-and-experience mismatch across the public-private divide. Those smarter graduates with MBAs and law degrees get hired by Wall Street for big bucks; their more-mediocre classmates wander off to work for the U.S. government for half the pay. Then, once the latter spend a while at the SEC or CTFC they naturally seek to cash in on their resume at some point -- after all, their experience, plus their insight into how a regulatory agency works, are valuable to Wall Street. They jump the fence and serve those they once regulated. So, in the end, the government doesn't even get the benefit of experienced mediocre talent.

Does that mean we should give up on regulation? Or regulate with the cynical conviction that our efforts don't really matter much, because Wall Street is just so politically well connected, so financially powerful, so much better endowed in both quality and quantity of people, that we don't stand a chance? This, to me, seems absurd. Why can't we instead challenge ourselves to do better?

Certainly, U.S. regulators often do appear hopelessly outmanned and outgunned. But they have one powerful advantage, too often overlooked: In a nation of laws, they define the rules for the playing field. In fact, they can define the playing field itself.

So what do we do?

Here are some philosophical thoughts toward smarter regulation. They are broadly prescriptive.

1. Move toward a more principle-based system of regulation.

One problem right now is that we lay out rules, in staggering detail, and anything not prohibited is generally assumed to be legal. That invites the creation of a loophole-seeking culture in the financial system. But why do we have to spell out everything? We don't always do this elsewhere in our legal system. The standard for determining guilt in a criminal case happens to be very subjective: "beyond a reasonable doubt." And what of the legal definition of pornography? It cites what an "average person" would find obscene applying "contemporary community standards."

Why can't we have more broad principles in financial regulation that say for instance, "If, when doing x, you do not follow basic concepts of generally acknowledged sound accounting (or some such), you can be prosecuted even if what you do is not expressly prohibited?"

Okay, I know, possible objections:

Accounting is complex; there are various methods of accounting. But still, there are basic principles that should be adhered to. Why can't these be enforced broadly? For instance, the treatment of special purpose entities in this crisis made absolutely no sense to me. How can a bank not hold regular reserves against an SPE's assets yet immediately pull the same assets onto its books as soon as the special vehicle gets into trouble? This shouldn't be allowed; basic common sense should tell us that. You shouldn't need a specific rule prohibiting it.

Principle-based accounting will create a lot of uncertainty, which will stifle innovation. Well, it's not clear that financial innovation has done us much good in the first place. The truth is, we probably don't need as much of this vaunted "innovation" as we now have. Still, it's worth noting that a more principle-based approach doesn't preclude being able to spell out certain rules, especially as they apply to simple, necessary functions of the banking system. Once you start innovating outside of that sphere, then you would be increasingly on your own.

2. Add criminal penalties. Subtract certain regulations.

Basel II, and regulatory regimes like it, invite a lot of mind-bending game playing for financial institutions. Under Basel's international standards, banks must set aside a certain percentage of reserves for assets of class x, but a different percentage for class y, and so on. So if you're a bank, you obviously have an incentive to transform your assets into favorable classes that require less in reserves.

But, as Mike points out over at Rortybomb, just because the regulators say you must have, say 8 percent capital on hand, doesn't mean you have to go down to 8.0001 percent. You can set aside 12 percent. Or 16 percent. You should be making that calculation based on the market, your collection of assets, and how much you think you'll need. Unfortunately, when that 8 percent number becomes enshrined by regulators, it then becomes a floor to evade your way around. So the banks try to get to 8, then to gain a competitive edge, they look for a way to secretly go down to 6 percent, and make more profits off the higher leverage.

Ironically, here you can argue that certain types of regulation make things worse (and indeed, some people are looking at that now: see Mike's full post above). What would be a way to solve this problem? Perhaps we could loosen and simplify certain capital regulations, but then put into place a hammer on the backend to make bank executives more subject to criminal charges (and subject to personal bankruptcies) when they gamble unwisely and lose.

After all, remember one significant thing about the landscape before all the investment banks went public by selling stock. Under the old partnership model, before they got to play with other people's money, they were a lot more careful. The partners had to eat the losses. So they were careful to stay on top of the risk.

3. Seek to create "natural brakes."

A "natural brake" is something that tends to slow you down, in a simple and automatic manner, without messy intervention. I would compare it to shifting into first gear when rolling downhill in a car. The lower gear automatically helps to slow the vehicle.

What are other natural brakes?

Housing bubble brake: Some mechanism that kicks in when average house prices climb high enough relative to average rents/incomes. This sort of brake means you don't have to try to judge that tricky, right moment to intervene on a bubble. Not only is that judgment hard to make, but it's complicated by political considerations and the fact that you're basically removing the punch bowl while the party is rockin' and rollin'. Not a popular move.

How might this brake work: When house prices reach a certain multiple of rents, then homebuyers have to put down x percent more in a deposit to buy a home (this isn't an original idea; others have proposed it). This acts as a nice natural brake because, when homebuyers are forced to increase their downpayment, more will shift toward renting, and the price of rents will nudge up, and the price of homes nudge down. A more-normal equilibrium will naturally be reached.

Short-selling is a natural brake for the stock market. It's often demonized during a down market, but the shorts take the air out of bubbles. They exert downward pressure on share prices. They keep owners of stock more honest and help protect them from getting burned in momentum-driven rallies.

What are natural brakes that could be employed by bank regulators? I'm sure there are some good ones out there. For home prices, as I noted above, we could start by creating a linkage between the market costs of buying vs. renting, using each to keep the other in a sensible range.

Tuesday, September 22, 2009

Oh, So Now You Don't Want the Annual Pecan Sale Flier?

The arrogance of Wall Street throughout this financial meltdown and aftermath never ceases to amaze me. I know it shouldn't, but -- these are the kind of guys who, on the hangman's scaffold, would take a moment to harangue the executioner about the rope burns they're getting because the noose is too tight.

First they grumblingly took billions in bailout dollars from Paulson, then refused to say what they were doing with any of it. Then, after Geithner came up with a plan to buy up their toxic assets using generous federal backing, a plan that would have led to some overpaying in their favor, they decided they didn't want any part of that. And now they're looking forward to big bonuses again this year, as the rest of us watch unemployment creep into double digits.

Sometimes it just makes you want to laugh until you cry. You know, the tears of the world-wise clown. What put me in this mood was a story up at the Huffington Post revealing the tussle now taking shape between Bank of America and Congressional Democrat Edolphus Towns.

Bank of America of course closed a deal to buy Merrill Lynch on Jan. 1. What BOA shareholders who approved the deal didn't realize is that Merrill Lynch had authorized paying its employees almost $6 billion in bonuses ($3.6 billion was the final amount that went out the door). And, to top it all off, the investment bank turned out to have a lot of garbage assets on its books. So a very reasonable question being posed by irked shareholders: what did the top executives at the bank know about the Merrill bonuses and financial problems, and when did they know it?

Top-level Bank of America executives are, not surprisingly, hiding behind the skirts of their attorneys, citing attorney-client confidentiality. Towns, bless him, isn't settling for that. During an investigation, Congress can choose to override that attorney privilege. So the New York Democrat asked the bank some tough questions about the Merrill deal and about federal backing the bank has received, and requested that relevant documents be sent to him.

This is where the comedy starts. What would an arrogant bank do? Well, first carefully redact any useful information (which it did). Then, second, send the Congressman all manner of crap in its files, just to keep his staff busy. That it did too. Towns expressed his displeasure over this tactic in a letter to CEO Ken Lewis (it's embedded in the article linked above):
Many of the documents produced so far are clearly irrelevant to the Committee's investigation ... For example, you sent numerous copies of emails you received from your own employees expressing admiration for your "awesome" performance on 60 Minutes. You also included copies of emails alerting Bank of America employees to discounts at Wal-Mart, Target, and Costco; an announcement of the "Annual Pecan Sale," featuring "This Year's Crop of Mammoth Pecan Halves;" and an invitation to attend a conference on investment in East Asia, written in Chinese.
Towns' tone is restrained, but he knows what's going on. Bank of America is just waving its big fat middle finger at him. And why not? That strategy has worked well for the nation's big banks so far.

Friday, September 18, 2009

George Bush Funnies, Sept. 18 Edition

A former George Bush speechwriter, Matt Latimer, is attracting some attention on the pages of GQ with an unusually revealing look at his former boss. While writing about how clueless Bush was about Hank Paulson's helter-skelter efforts to save the financial industry from melting down last fall, he happens to reveal:
At one point, during another of our marathon speechwriting sessions, Steve Hadley and Fred Fielding, the White House counsel, let us know that the president needed an FDR line—like “We have nothing to fear but fear itself.” The president had his own suggestion for such a line, however: “Anxiety can feed anxiety.” So we produced a speech with no real information and our FDR knockoff line.
Okay, so no one ever claimed George Bush was a great orator. "Anxiety can feed anxiety" ... not the kind of writing that stirs the soul.

Look at FDR's great line. The words have a rhythm, a cadence, as they roll off the tongue. They are simple words (six of the eight are monosyllabic); combined they are like a genius arrangement of common musical notes that creates an impression that lingers in the mind. Then there is the message itself: FDR starts with "we have nothing to fear" -- the construction boldly embraces all Americans in a time of worry and trouble; the phrasing isn't diluted by auxiliary verbs that hem and haw. FDR doesn't say, "we shouldn't have anything to fear" or "we might have nothing to fear ... we'll see, once the unemployment numbers come in next month." And then the powerful backend of the sentence "... but fear itself." This is where the line soars to its zenith, sharply pivoting on the word "but," slamming us with that strong word "fear" again -- and then the final poetic touch, the "itself" serving as intensifier that provides a soft padding at the sentence's end, emphatically crowns the point, and arouses in us the courage that we had forgotten we possessed.

Then of course we have George Bush's, "anxiety can feed anxiety." "Fear" is something powerful, the stuff of great literature. "Anxiety" isn't; it's Woody Allen mumbling to himself and worrying over a hangnail while hustling off to see his analyst on Fifth Avenue. It's one of those ugly four-syllable words that belongs in the linguistic territory of psychotherapy. And then how does this sentence's imagery work exactly? There is the word "feed" -- it's a concrete word, suggesting something being eaten, consumed. But then is anxiety number one feeding something else to anxiety number two? Is anxiety simply feeding "on" its own anxiety? The picture that comes to mind is somewhat muddled -- in fact, what some Bush critics would argue is a fair depiction of the former president's brain.

"Anxiety can feed anxiety." I'm going to pass a non-poetic judgment on this, as a sentence meant to call forth echoes of FDR's famous line. Here it is: yuch. If you put a finite number of monkeys before a finite number of typewriters (I'm thinking 100 monkeys and 100 typewriters), chances are excellent that within five hours they could bang out something that would beat this.

Marginally better, though more prosaic-sounding, is "Anxiety can feed on itself." Of course, if Bush had used that line, he would have had to credit that great rhetorical work, "Why Zebras Don't Get Ulcers":
So an aroused amygdala activates the sympathetic nervous system and, as we saw in the previous paragraph, an aroused sympathetic nervous system increases the odds of the amygdala activating. Anxiety can feed on itself.

Thursday, September 17, 2009

The Annals of "Whatever Happened to PPIP?"

Remember, PPIP was the Geithner plan rolled out amid much fanfare back in March. The government was to pony up funds and partner with private investors to buy up crappy assets clogging bank balance sheets, through a series of auctions. This act of Roto-Rootering our financial system was depicted as necessary to restoring the banking industry to the pink of health.

Early on, I predicted the plan would die because the banks wouldn't play ball. They wouldn't dare, knowing that they'd have to revalue huge chunks of their assets once the investors' low bids revealed how little their loans and securities were really worth. My conviction hardened as the year went on.

So naturally, I was more than a little intrigued by this story:
FDIC Names First Winner in Toxic Asset Program

So did I get this wrong? Is the program finally stumbling out of the starting gate? Well, it turns out my reputation remains intact. Check this out about the first winning bidder (bold mine):
Fort Worth, Texas-based Residential Credit Solutions Inc. is paying $64.2 million for a 50 percent stake in a new company that will have about $1.3 billion in home mortgages from the failed Franklin Bank.
Yup. The picture starts to become clear. We're not subsidizing investors who are buying the assets of sick banks to make these lenders healthier. We're subsidizing investors who are buying the assets of stone-dead banks. This just flat-out doesn't make any sense. Let's read on to see why:
The program is part of the government's public-private partnership to guarantee private investors' purchases of toxic assets to help banks raise new capital, get credit flowing and aid the economic recovery.
So buying up the assets of failed Franklin Bank will help it raise capital and allow it to increase lending and ... wait a minute ... it's DEAD. D-E-A-D. Put a finger under its figurative nostrils. This bank can't fog a mirror any longer.

This bank is like the parrot in the Monty Python sketch that's been stapled to the perch and sold to an unwitting customer. Franklin Bank is a dead parrot. Why are we lavishing subsidies on a dead parrot? The bank can't raise any more capital or lend half a million to Bucky's Sub Shop for a new store on the east side or sponsor the Little League team this season because it's PERISHED, KAPUT, EXPIRED, GONE TO THE GREAT FDIC GRAVEYARD IN THE SKY.

Then we have this chuckle-worthy paragraph. I can't tell if the reporter is trying to wring out a little dry irony:
The FDIC said it will analyze the results of the RCS-Franklin Bank sale to determine whether the same process could be used to get toxic assets off the balance sheets of banks that are still open and functioning, as opposed to failed banks.
So essentially PPIP has turned into the worst of all possible worlds. Think of it as a "vulture" subsidy -- a way of slipping a little money to private investors to buy up crummy assets of failed banks. The problem is, you shouldn't need to do this. Just take the low bid sans subsidy, for crying out loud. The FDIC has a process firmly in place for selling off assets of failed banks.

Why they're using PPIP for this purpose is beyond me. The machinations behind the federal bailout(s) of the financial system have grown downright impenetrable.

Wednesday, September 16, 2009

The Annie Le Murder: Three Questions

Okay, I know I'm drifting afield again, but I have a weak spot for true crime stories and Jane Velez-Mitchell's yammering on HLN. Annie Le is of course the 24-year-old Yale graduate student whose body was found crammed inside the wall of a laboratory on campus, five days after she went missing. Medical technician Raymond Clark has been declared a "person of interest" (these are almost always suspects, though the police have quite pointedly avoided using that word in Clark's case).

I'm following all the dribs and drabs of coverage of this sad story, but there's not much news. There are three questions I can't figure out why no one is talking about (and if they are, please note where and I'll happily shut up).

1. The police found bloody clothes, apparently belonging to the murderer, behind some ceiling tiles. The police also have video from some 70 cameras outside the building showing everyone who entered and left. Then why don't they just match the clothing to the video images of everyone who entered? After all, we know exactly what Annie Le was wearing, because it was clear on the image that the video captured of her entering the building. Or did the killer bring a few pairs of clothes to work that day? In which case, you'd start looking hard at people coming to work carrying odd bags, right? Is anyone in the media asking this question about whether police have tried to match the bloody clothing to the video images?

2. The New Haven Independent quoted an anonymous student who said she contacted the FBI after someone held open for her the door to the garage adjoining the lab building, on the day of Annie's disappearance, and he happened to have a quarter-sized blood stain on his shirt. She described the man as white skinned with reddish-brown hair and eyeglasses. Has anyone noted the shade of Clark's hair? Does he ever wear glasses? The bigger question: why hasn't the New Haven reporter who broke the story gone back to this anonymous student and asked her, now that Clark's face is all over the news: So, was that the guy you saw that day?

3. The killer's bloody clothes were allegedly found behind ceiling tiles. So if he stashed them there, what did he wear home that night? Did he bring a second set of clothes with him to work, with full knowledge of what he planned to do? Or how did he get fresh clothes, in an inconspicuous way? The most likely scenario would be that he simply donned some kind of lab clothing, maybe a loose-fitting hygienic smock. But in that case, wouldn't the police notice on the surveillance video that Man X enters wearing one set of clothes and leaves wearing another?

Overall, my thinking is that the police have a really, really good idea who did this. They may be waiting for the DNA tests to be absolutely sure, but I'm betting they knew the identify of their killer days ago.

Tuesday, September 15, 2009

Judge Rakoff Stands up for the Little Guy

Just when you think cynicism rules the land and nothing will ever get any better because everyone's in someone else's pocket, through campaign contributions to the left and right and everyone in between, or regulators going soft on misdeeds because of plans to eventually fence-hop to the private sector to land cushy jobs, or Goldman Sachs populating the upper ranks of the U.S. Treasury with its own operatives ... well, along comes this heartening news:
A federal judge on Monday rejected a $33 million settlement between the Securities and Exchange Commission and Bank of America Corp., saying the SEC's accusations of inadequate disclosure by the bank over bonuses paid at Merrill Lynch must now go to trial.
The judge was no doubt incensed: the $33 million would have been paid by the shareholders of the bank -- essentially the same ones who did nothing wrong and got screwed in the first place! The U.S. district judge, Jed Rakoff, has immediately been lionized as a new and rare kind of hero. Basically, he called out the SEC for an all-too-familiar bit of puppet theater: SEC brings civil charges against some alleged wrongdoer, the two sides wrangle behind the scenes, both eventually agree on a relatively small fine while the accused party never has to agree to guilt or wrongdoing.

But Rakoff, bless his justice-loving soul, would have none of it:
Rakoff, in his ruling, found that the settlement "suggests a rather cynical relationship between the parties: the SEC gets to claim that it is exposing wrongdoing on the part of the Bank of America in a high-profile merger, the bank's management gets to claim that they have been coerced into an onerous settlement by overzealous regulators. And all this is done at the expense, not only of the shareholders, but also of the truth."
Here's a short roundup of what some other bloggers are saying about the judge who dares to stand up for what's right:

Yves Smith at naked capitalism:
Oooh, this is turning out to be fun. Judge Jed Rakoff is not putting up with Wall Street business as usual ... and SEC lack of spine.
Zero Hedge:
One of those hopefully seminal moments, when someone, somewhere decided to take a stand against the perpetual engine of corruption, greed, and cronyism.
Felix Salmon:
I hope this sends a clear signal to Mary Schapiro: quiet bilateral settlements with companies should come to an end, and as a rule all companies paying fines should at the same time admit, in public, exactly what they did wrong.
Randomly Noted:
I recognize that Rakoff is known for his maverick ways, and I also realize there’s a certain Schadenfreude involved in figuratively watching a judge point a finger at the executives atop a big bank as the country nears the one-year anniversary of an economic crisis largely caused by a finance industry gone awry. None of this detracts from the refreshing simplicity of Rakoff’s approach, and his questions.
Crime and Federalism:
Word on the street is that you do not play Judge Rakoff for the dupe.
Contrarian Musings:
It always irks me when companies or executives are allowed to pay a fine without admitting wrongdoing and finally a judge has the guts to call a spade a spade.
jr deputy accountant:
Go Judge Rakoff, go!!
Jed Rakoff for the Supreme Court!

Sunday, September 13, 2009

5 Reasons NOT to Make the Fed the Systemic Risk Regulator

I realize this debate peaked about three or four months ago, but wanted to get my two cents in. Originally I waffled on whether the Fed should take on this role. Absent compelling evidence, I waffle no more. I'm not in favor of having the Fed -- the powerful central bank the U.S. created almost 100 years ago -- regulate systemic risk in our financial system. This is why:

1. The Fed's independence -- standing on high ground, removed from the ebb and flow of political currents -- is more liability than asset. My thinking here is straightforward: no body composed of any number of wise men will successfully manage all threats of systemic risk. However, when the designated risk regulator does egregiously and clearly screw up, I think there should be clear, well-defined lines of accountability.

2. The Fed is too opaque. Watching the disclosure battle between the Fed and Bloomberg News makes me more than a little nervous. The Fed doesn't want to reveal the companies taking part in its emergency lending program, as well as how much these companies have borrowed and what collateral they have put up. This bothers me a lot, because this is a multi-trillion dollar program, operating in the dark, and the U.S. taxpayer is clearly on the hook if the Fed's bets go bad. Perhaps in the heat of a crisis you can make the argument for secrecy. A full year after the Lehman bankruptcy, that argument no longer holds water. We need regulators committed to transparency.

3. The Fed doesn't have the regulatory chops. The Fed just hasn't shown itself to be much of a regulator, period, over the decades. That's simply not what it does very well. Just look at and listen to Bernanke. He has the manner of an economist you'd find toiling wonkishly in a backroom at the World Bank. If you're unconvinced of my point, check out the latest: Fed Failed to Curb Flawed Bank Lending, Inspector General Says.

4. The Fed was wrong about this current crisis. This is far from an original point, but bears repeating. That's because Alan Greenspan was the closest thing we had to a systemic risk regulator in the runup to the credit meltdown. The most casual-seeming of utterances that fell from his lips had the power to throw markets into convulsions. He could have done more to deflate the housing bubble than an army of rank-and-file regulators by just expressing concerns about what was going on. But the fact remains he didn't see anything wrong.

5. For symbolic and functional reasons, we need fresh ways forward. I'll make reference again to the recent internal report on how the SEC botched the Bernie Madoff investigation: There is a seriously deep level of rot in our regulatory institutions. It's incompetence of such a staggering dimension that outright corruption almost seems preferable. In the face of that, I think that we need to try an entirely new way forward for regulating broad risks to our financial system.

So what do we do? I think that the Fed should be a strong voice at the table when it comes to identifying systemic risks. But I think we need many, many voices at the table. In the end, we also need an agency that will operate with something rare in this crisis -- transparency. And we need someone with the moxie of an Elizabeth Warren at its helm, not another lapdog for the financial services industry.

Saturday, September 12, 2009

Thinking about the Weather: Probability of Precipitation

It's raining. That's a matter of pressing concern at the moment (9:40 a.m.) because, before night falls, I'd like to get in my 26-mile bicycle ride. So I suddenly find myself with an intense interest in that odd probability figure so often bandied about by your friendly neighborhood meteorologist, "chance of rain." (Note: if you're looking for financial commentary today, sorry -- it's Saturday, and my Derivatives Muse has left the building.)

But what does a 30% chance of rain actually mean? Or, in my case, a 50% chance -- that's the grim outlook today for where I live. Does it mean it will rain 50% of the day? Or that, at any moment I step outside, I have a 50% chance of getting wet? I've studied some meteorology, so I was pretty sure that I knew roughly what it meant. But I still had some questions.

Online I soon found this from "The Straight Dope" from Cecil. His answer was sort of like "Percentages for Dummies" -- a bit superficial and not quite what I was looking for:
When you hear there's a 10 percent chance of rain, that means that out of the last 100 times the weather conditions were just like they are now, it rained 10 times.

Yeah, yeah, I knew that part already. It just sort of recapitulates the essence of probability ("If you poke a bear 100 times, and 10 random times he growls at you, there's a 10 percent chance he'll growl at you if you poke him again.") Cecil's response dodges the intriguing questions, such as does a 50% chance of rain mean that that's the probability it will rain somewhere in town, or rain specifically on my head?

The answer is here (I won't drag out the suspense). This explanation comes courtesy of the National Weather Service, so this is the final authority speaking. Below is the long version of the weather agency's explanation for "probability of precipitation," or PoP. It's bound to make some heads hurt among the numerically challenged:
Mathematically, PoP is defined as follows: PoP = C x A where "C" = the confidence that precipitation will occur somewhere in the forecast area, and where "A" = the percent of the area that will receive measureable precipitation, if it occurs at all.

So... in the case of the forecast above, if the forecaster knows precipitation is sure to occur ( confidence is 100% ), he/she is expressing how much of the area will receive measurable rain. ( PoP = "C" x "A" or "1" times ".4" which equals .4 or 40%.)

But, most of the time, the forecaster is expressing a combination of degree of confidence and areal coverage. If the forecaster is only 50% sure that precipitation will occur, and expects that, if it does occur, it will produce measurable rain over about 80 percent of the area, the PoP (chance of rain) is 40%. ( PoP = .5 x .8 which equals .4 or 40%. )

Got it? In other words, "chance of rain" breaks down into two parts. First, the forecaster looks at a given area -- let's say the metro region of Boston. He crunches his models and concludes that there's a 50% likelihood it will rain somewhere in Boston. Then he analyzes how much of Boston will get wet, if it does rain. If he decides it's, say 40% of the area, then the official "chance of rain" for Boston becomes 20%.

If you don't like percentages, and you certainly don't like them on a combo platter, as I've just served up, here's the easy way to understand that figure: there's a 20% chance that any given point in the Boston area will be rained upon.

Okay, now we're getting somewhere. "Chance of rain" is always tied to a spatial component. After all, it doesn't make much sense to talk about the chance of rain without talking about some specific place that's either getting rained on or not getting rained on. Further, we're talking about any particular point in that area (this raises an interesting question -- how big is our point? The size of a period at the end of a sentence, or a beach ball, or a helicopter landing pad? And what happens to the probability of precipitation if we increase the size of the point? Naturally we would expect the percentage to rise, though only by a very small amount -- there will be a rare rain event where the edge of the beach ball gets wet but not a small dot in the middle.)

"Chance of rain" isn't only linked to a certain geographic area though. It also needs a temporal component. This has interesting implications. Illustration: what is the chance of rain for a given point in that metro area of Boston for the entire year of 2009? Well, one would expect that to be about 99.9999% -- it's practically inconceivable that a given location in Boston won't receive some rain, at some point during a year.

Now, running that idea in reverse, we'd expect the opposite to occur: that if there's say a 90 percent chance it will rain at a given point in Boston during a certain week, the likelihood that it will rain at that point on any particular day would be lower. (40% maybe? or even as low as 20%?)

So "chance of rain" lacks sufficient precision without an accompanying timeframe. We all know this, but ordinarily don't give it much thought. The National Weather Service tells us there's a 40% chance of rain "this afternoon." Few of us would then say, "What does this afternoon mean exactly? 12 to 4? 12 to 5? Because how you define the length of the afternoon affects the resulting probability."

Convenient example: has started giving "hourly" forecasts for chance of rain (actually, they represent three-hour blocks). Today, for where I live, there's a 50% chance of rain. And all of the shorter blocks of time also give 50%. Seems logical at first. But what's wrong with this picture?

Recall what a 50% chance of rain for the day means: sometime, over 24 hours, any given point in a certain region has a 50% chance of experiencing rain. The rain could fall at 5 a.m., or noon, or 11:59 p.m. But it will occur sometime in that 24-hour cycle. But when you start chopping that 24-hour cycle into smaller chunks, the percentage for the shorter periods should fall. So when you have a 50% chance of rain over an entire day (and, to keep things easy, let's say the 50% chance is evenly spread over the day, ruling out fronts swinging through in the morning and exiting by the afternoon), a good meteorologist (and statistician) will realize that you don't by extension have a 50% chance of rain for any given three-hour period during that day.

Hope you enjoyed this little detour from the normal programming. By the way, it's still raining, at 10:46 a.m. My back of the envelope calculations indicate there's a 100% chance I'm not going anywhere for at least an hour ...

Friday, September 11, 2009

The Badly Bungling SEC: An Eye-Opening Tale

Today I want to return to the blistering report that the SEC's Office of Inspector General issued earlier this week. In 22 highly detailed pages, the SEC's internal watchdog retraced a succession of mind-boggling blunders that allowed Bernard Madoff, king of the Ponzi schemers, to escape detection for more than a decade and a half. In fact, the SEC wasn't even investigating Madoff at the time of his arrest; his own sons turned him in. He turned out to be the mastermind of a $65 billion fraud that suckered investors from pension funds and charitable foundations to wealthy individuals.

I want to return to this story because it's really important to appreciate how much rot we have in our financial regulatory system. Arguably, the SEC is worse than corrupt: with corruption, at least you have someone to arrest and you can purge any lesser wrongdoers from your ranks. Here we have what CBS News called nothing less than "jaw-dropping incompetence," and it appears to have been systemic. The inspector general's summary paints a picture of SEC examiners and investigators who are about as credulous as a bunch of six-year-olds on a snipe hunt.

From where I sit, the agency's lack of any investigative smarts or zeal whatsoever is the real, profound problem.

I mean, sure, there were the typical bureaucratic delays before the SEC's handful of half-hearted investigations got underway ("the start of the examination was delayed for seven months," pg. 10, "there was a significant delay (8 months) before the examination was commenced," pg. 12, "the enforcement staff delayed opening a matter under inquiry for the Madoff investigation for two months," pg. 17). But over a period of 16 years, even these long delays pale in significance. They don't explain how Madoff could wriggle free, again and again, from the SEC's clutches even as the regulators had a bounty of suspicions and evidence repeatedly dumped in their lap. (Harry Markopolos, who knew inside and out the kind of options trading that Madoff was supposedly doing to score his profits, chose a rather unsubtle title for his 2005 complaint to the SEC: "The World's Largest Hedge Fund is a Fraud.")

Neither does "inexperience" turn out to explain much of the regulator's failure; it's just a convenient excuse. True, there's an example given where a staff attorney fresh out of law school did most of the work in one of the five SEC probes into Madoff's operation. This does raise questions about why she was appointed to the team -- surely there was a more experienced hand somewhere yes?

Still, the bottom line is that even a newly minted lawyer should have a certain basic analytical skill set -- and that's all that was needed to put Madoff behind bars six times over. Despite the supposed complexities of Madoff's trading schemes, the case could have been cracked by anyone who had a critical mind.

Remember, Madoff bilked all his investors through a Ponzi scheme. And a Ponzi scheme is like a shaky house of cards: you pay the first wave of investors by using money from the second wave, and make sure you keep growing so that the structure doesn't collapse. Of course the brains behind the fraud have to invent a front for outsiders, fabricating at least a few superficial documents to "explain" the profits. A dogged investigator (or even a not-so-dogged one) can unmask a Ponzi artist though by simply daring to shine a light behind the curtain. In other words, was Madoff making trades that would support his reported gains?

That's Ponzi Basics 101. But the SEC's clueless cops, on numerous occasions, passed up opportunities to verify Madoff's trades through a third-party source, such as the Depository Trust Company (DTC).

The investigators also missed easy, obvious stuff.

For instance, go all the way back to 1992. The SEC was investigating an investment firm, Avellino & Bienes, suspecting a Ponzi scheme. The regulator finally ordered that all the investors in A&B be repaid. And they were, but no one thought to inquire where that repayment money was coming from. It so happened that Madoff controlled A&B's investments, so the SEC investigators should have asked if a larger Ponzi scheme might be paying off the investors in the smaller one. An SEC examiner later said that looking at the source of funds was just "common sense." You don't need a degree from Harvard Law School to possess that.

Also there's a litany of instances where Madoff was caught by the SEC investigators in lies and inconsistencies. But they either accepted his pat explanations or never bothered to push harder to get at the truth.

Often they didn't bother to reach out for help, as a good cop would when faced with something he couldn't wrap his head around. When they did, they were sloppy. Look at February 2006, when the SEC's enforcement division contacted a sister division, in economic analysis, seeking aid in analyzing Madoff's trades. For two and a half months, no response came. The economic analysis staffers at last did review certain documents and concluded that Madoff's money-making strategy would not have done as well as he reported. Incredibly, however, this observation was never conveyed back to the people over in enforcement.

In that instance, someone might want to blame the economic analysis crew, but let's be fair: if you're a big-city cop investigating a case, and you don't hear from the fingerprint department in a reasonable amount of time, you grab the phone and give 'em a call. Failing to do so has nothing to do with inexperience. It's sheer bureaucratic laziness.

Madoff himself couldn't believe the agency's rank incompetence. He said he was once asked for his DTC account number, so his trades could be checked. At that point he figured the jig was up: an investigator would call DTC and it would be "end game, over." But the SEC never followed up, leaving him scot free and "astonished," he said.

And so this gross, almost unimaginable incompetence plagued the SEC, through Democratic and Republican administrations. The report reveals the agency to be so amazingly dysfunctional that, in my opinion, we may be better off abolishing it and starting anew.

By the final page of this document, the essence of the tragedy becomes all too clear: Madoff's fraudulent activities could have been uncovered quite simply at any time between 1992 and 2008.
When Madoff's Ponzi scheme finally collapsed in 2008, an SEC Enforcement attorney testified that it took only "a few days" and "a phone call ... to DTC" to confirm that Madoff had not place any trades with investors' funds.

Thursday, September 10, 2009

The Shape of the Recovery: Lopsided W

I'm making my prediction for what this recovery will look like. Here goes: lopsided "W."

In other words: the economy takes a dip (the first sliding line of the "W"), makes a brief upward surge (the crest in the middle, which is where we are now), then slides downward again, even deeper, before we begin climbing out of the hole.

Why "lopsided": I think the "green shoots" happy talk and the stock market's inexplicable lunge higher are going to wither and blow away ... leaving us in a state of renewed fright that will drive the economy lower than before. By this view, the next leg down will be the harsher one, thus creating a lopsided "W."

I hope I'm wrong. I really do. But the big problem, from where I sit, is that we haven't really stared down the beast that got us into this mess. We have changed little at the heart of our financial system, prosecuted few of the bad actors and avoided acknowledging how much rot still plagues the balance sheets of the big banks.

That brings me to today's must read, by guest blogger George Washington at naked capitalism: The Economy Will Not Recover Until Trust Is Restored.

The author's thoughts closely mirror my own and capture the broad reasons for my pessimism about this economy. The piece is a good roundup of how trust has broken down -- investors don't trust the stock market, big banks don't trust each other, citizens don't trust the government -- and why this lack of trust is, to be perfectly blunt, like a cancer that is keeping us ill.

Some highlights summarized:

1. The Fed's policy of flooding the financial system with money is misguided, eminence grise Anna Schwartz tells us (again). The Fed is treating the financial mess as one of liquidity (shortage of money). But it's actually a crisis of trust -- banks don't have faith in the reported soundness of each other's books. They are reluctant to lend to each other because they can't tell who really is and isn't solvent.

2. Robert Reich: "The trouble, in a nutshell, is that the financial entrepreneurship of recent years — the derivatives, credit default swaps, collateralized debt instruments, and so on — has undermined all notion of true value." So again: investors have trouble "trusting" the price tag on a range of complex products.

3. This, from the author: "I would argue that our economy is not fundamentally stabilizing (notwithstanding a couple of temporary “green shoots”) because the government and the financial giants are taking actions and releasing data which encourage more distortion and less trust. The crisis will deepen unless honest and transparent accounting is used, investments become transparent and understandable again, and the government stops gaming the system for the benefit of the big boys."

4. Americans have suffered the psychological wounds from a betrayal of trust. Regulators that were supposed to protect us from greedy financiers running amok were nowhere in sight. Psychologically, the trauma of loss that citizens experienced is compared, perhaps a bit hyperbolically, to the devastating blow of Sept. 11.

5. Obama's team is simply trying to restore confidence instead of trying to address the underlying issues that caused the erosion of that confidence. This will backfire, Yves Smith predicts. If the economy does make a second, more pronounced dip, people will be more warier when the government starts talking again about "green shoots" and "recovery," having been burned once. That distrust will act to hamper the actual, real recovery.

Sunday, September 6, 2009

Will Wall Street Finally Meet Its Waterloo?

That thought at least ran through my head this morning when I read this in the Times: "Wall Street Pursues Profit in Bundles of Life Insurance." It's a ghoulish little activity -- I use "ghoulish" with full intent, as the word derives from the practice of plundering graves for profit. Which, I imagine, could very well be Wall Street's next stop: buying up cemeteries, then disinterring the bodies and yanking gold and diamond rings off bony fingers, tossing teeth that have inlaid gold or silver into a bucket to be melted down, rummaging the corpses with a cold eye for any items of value ... But I digress.

The NYT explains the business at hand quite succinctly:
The bankers plan to buy “life settlements,” life insurance policies that ill and elderly people sell for cash — $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to “securitize” these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die.

Well, death is recession proof. Everyone's gonna die. Now if you can identify the sickest members of society, who are also most desperate for quick cash, you can probably score some pretty nifty returns.

So get a load of this: You're Wall Street, pretty much universally despised by average Americans for having played a key role in precipitating a financial crisis of epic proportions, one that's pushing unemployment up into double digits. An impartial observer might assume that you'd be in duck-and-cover mode right now, trying to keep a low profile so that your CEOs and friends don't end up swinging from the lamp posts, but actually, that's not the Wall Street way.

You don't lose your bluster at all. You've got Washington politicians and officials licking out of your hand, throwing bailout money at you. You've got the Federal Reserve backstopping you by allowing you to borrow cheaply using crap assets as collateral. Why try to be humble? You rev up the bonus machine again; how can you keep all this talent that almost bankrupted you if you don't pay industry-competitive bonuses? You wade back into the deep end of the risk pool, as Goldman Sachs has done. You even return to bundling and selling the same kind of junky securities that got you into this mess. And now you figure out a way to create a money machine by cashing in on the sickest and most defenseless members of society.

Sometimes I wonder if Wall Street banks actually think about their image. Because this has to look just absolutely horrible. I mean, there's not much that would look worse, short of profit-making euthanasia squads that roam the land.

Which brings me to: Might this be Wall Street's Waterloo? One of these days, the big investment banks are going to push things too far. Could this be the moment? Americans aren't terribly bright -- one out of five thinks the sun revolves around the earth -- but there are simple acts that everyone can understand and becomes enraged about, such as the bonus culture on Wall Street. Everyone on Main Street who collects a paycheck can easily figure out that he earns only a fraction of what the average Goldman Sachs banker will take home in bonus this year.

Up to now, the life settlement business has always operated on the fringes. It seems a bit ghoulish in any context, but reasonably, it's done some good, helping people who are, say, terminally ill get a little spending cash for their final days.

But if Wall Street turns life settlement into a profit center, that will change. A large-scale, organized business will result in life insurance rates being jacked up for the rest of America, because insurers now count on a certain percentage of policies to lapse through a failure to pay. Here's the problem: Wall Street banks won't miss a $200 monthly payment on Aunt Clara's life insurance policy if they're sure she's going to croak in a year or two and they can collect $100,000 or so. Fewer policies will lapse, and because of this, insurers' payouts will rise. And they'll compensate by charging all of us more.

But beyond this, I have to wonder if Wall Street bankers really thought this one out. Sure, there's money to be made, probably good money. But this is a public relations nightmare in the making. Can the Street really be this tone deaf?

Thursday, September 3, 2009

Barry Ritholtz Gets It Right

I like the frank, no-holds-barred style of Barry Ritholtz. The author of Bailout Nation appears here in a very good Q&A that, while you're idly chewing on that morning donut, you'd do well to check out. The title is a bit dull (Barry doesn't lack for imagination -- not so, perhaps, the headline writer): "How the Bailouts Could Have Gone Better."

Here are the major takeaway points I found, and they're very good:

1. There was a non-bailout way to bail out AIG and Citi. Rescuing them wasn't a binary proposition: let them perish or save them by showering them with geysers of money, no questions asked. While some might call Ritholtz naive on his analysis here, I think the bottom-line point holds up: we could have struck a much harsher deal with firms such as Citigroup that were doddering at death's door.

2. A major problem in this financial crisis is that, as Americans, we like to avoid "ripping off the Band-Aid," as Ritholtz would say. In other words, we don't like pain. Agree completely.

3. The concept of "moral hazard" -- i.e., implicit government guarantees causing big banks to act more recklessly than otherwise -- has been scoffed at, but the truth is we've already seen it, Ritholtz notes. Lehman could have been saved earlier by Warren Buffett. Instead it said, "No thanks," expecting that the U.S. government would eventually sweep in with a sweeter deal.

4. The public company structure of the large banks WAS a significant problem in the escalation of risk-taking. I'm going to quote straight from Ritholtz on this last point, because it's a big theme that's emerging from this crisis, that giving people who like to play with money a warehouse of other people's money to play with can create big undesired consequences:
By the way, there was a huge amount of capital in private trusts and partnerships and private investments. Not one of those blew up. When it's a public firm, you can't go after senior executives' personal assets if it collapses. But if it's a private operation, you can. And none of the guys with their own money on the line went belly up.

Wednesday, September 2, 2009

First Reaction to Madoff Report: W-o-w

The inspector general has dropped a big fat report on us why the SEC blew the Bernie Madoff investigation over a period of ... 16 years. That's right. The securities industry watchdog could have caught Madoff's investment Ponzi scheme as early as 1992. The executive summary (here, on a WSJ blog) is 22 pages crammed with missed opportunities so stunning they'll leave you breathless.

The short version of why the SEC investigators screwed up: Inexperience. Incompetence.

I'm not entirely satisfied with either of those explanations, and I hope to have time to return to this subject tomorrow. But I wanted to weigh in on this quickly because I think there's a more common-sense, fundamental reason the SEC failed, again and again, to catch a multi-billion-dollar Ponzi scheme that wasn't executing any trades (which no one bothered to check!!!!)

Here it is: The SEC is the securities industry "cop on the beat" right? When you want to hire a good cop/detective, what do you look for? Someone who is innately skeptical. Who is a digger. Who isn't satisfied by the first answer he gets. Who invests a little "shoe leather" in tracking down answers. Who, if he doesn't understand something, finds someone who does -- and has that person explain it to him, nice and slow. To be a good securities cop, you don't necessarily have to have an IQ of 170 and understand all the intricacies of options trading -- but you need to be smart enough to know where you have knowledge deficits and dogged enough to fill them.

This is where the SEC messed up, big time. I don't know who it has hired to fill its positions. Maybe the HR department is just massively dysfunctional. But what is clear is that our top securities cops are temperamentally and constitutionally unfit for their jobs. It's that simple. The hell with the inexperience part. The trouble is, they don't think like friggin' cops. You don't hire Fred the Meek 9-5 Insurance Actuary to investigate a string of killings on the west side.

Bold idea: dissolve the agency and reconstitute it. Let's stop pretending it's only this guy making a mistake here, or that guy over there. If you think that's a draconian solution, read the IG's report. The problems are really, really deep-rooted. I don't think they can be solved by firing a few people. Hell, maybe the agency should advertise for a few law enforcement officers and learn how a real cop investigates possible crimes.

Tuesday, September 1, 2009

Sheila, What Are You Smoking?

That was my reaction to Sheila Bair's op-ed piece in the New York Times today. Bair argues against creating a super-regulator to oversee all U.S. banks. Her reasoning unfortunately wouldn't pass muster in a high school Debating 101 course.

Let's deconstruct the thought processes of the Bair-ian mind.
The principal enablers of our current difficulties were institutions that took on enormous risk by exploiting regulatory gaps between banks and the nonbank shadow financial system, and by using unregulated over-the-counter derivative contracts to develop volatile and potentially dangerous products ... The creation of a single regulator for all federal- and state-chartered banks would not address these problems.

Okay, let's assume her "principal enablers" analysis is correct. Now tell me which model you'd have more faith in to regulate a banking system: a fractured hodgepodge of smallish regulatory bodies or one "super regulator" that probably has more awareness of systemic issues in the industry. Who is likely to be more vigorous in regulating OTC derivatives and exposing the dangers of the shadow banking system? The problems that really killed us in this financial crisis didn't come from the state or local level, they came from Wall Street. It was the massive intertwining of institutions and interests, and the securitizations, and the derivatives ... these problems didn't percolate up from the community banks. You need a Big Boy Regulator to get on top of this stuff.

Anyway, unfazed, Bair plows on. Not for her to do too much heavy-duty lifting in the thinking department. She charges that empowering a super-regulator "would endanger a thriving, 150-year-old banking system that has separate charters for federal and state banks." Okayyyyy ... and that is why?

Here's where Bair pulls off a neat little rhetorical trick. I don't know what the official name is, in debate lingo. Let's just call it "being misleading as hell" (though I think it's called "assuming the conclusion" or some such). She exalts local community banking (fair enough) and then suggests that these are the banks that would suffer under a super-regulator.
Concentrating power in a single regulator would inevitably benefit the largest banks and punish community ones. A single regulator’s resources and attention would be focused on the largest banks. This would generate more consolidation in the banking industry at a time when we need to reduce our reliance on large financial institutions and put an end to the idea that certain banks are too big to fail. We need to shift the balance back toward community banking, not toward a system that encourages even more consolidation.

Now, notice something interesting. Bair gives ABSOLUTELY NO REASONS FOR THESE STATEMENTS. "A single regulator's resources and attention would be focused on the largest banks." Um, why is that? Are you saying that big regulators naturally gravitate toward big entities? Is this an ironclad law, the "Third Law of Regulatory Attraction"? So it's then impossible to create a big regulator that, say, has a division called "Division in Charge of Local and Community Banking"? Or if you created that division, you're suggesting it would be ineffective? Yes? If so, on what grounds? Have you done a study? Or has someone else?

Bair, apparently believing that like God she doesn't need footnotes (or justification) for what she says, steams on and concludes that "a single-regulator system could also hurt the deposit-insurance system." Right! And that's because ... uh ... we're waiting, Sheila ... actually she doesn't give any reason there either, except to note that the all-powerful regulator might interfere with the FDIC's role in protecting depositors (now her agenda starts to grow a little more clear -- her column, sadly, just reflects a turf war among bureaucratic regulators; none of them is thinking out of the box, just trying to poke you in the eye if you get too close to dismantling their little fiefdoms). Of course the FDIC -- probably the best of class of the banking regulators, I'd argue, so I certainly like 'em -- could be rolled into the super-regulator, pretty much intact. What about that? But then of course, that leaves Ms. Bair not running an agency of her own (the FDIC), but rather a division of the super-regulator. And, you know, that doesn't look quite as nifty on your resume.

Bair's solution:
I have advocated the creation of a strong council of federal financial regulators.

So let me paint the picture for you, using the current Three Stooges Model of financial regulation we have now. Right now, Larry says he thought that Moe was regulating AIG. Moe says he thought Curly was regulating AIG. Now, in the new vision proposed by Bair, Curly can blame it all on another layer of bureaucrats, the "strong council of federal financial regulators."

Bair isn't done. Bair with me (couldn't resist):
One advantage of our multiple-regulator system is that it permits diverse viewpoints.

Okay, I know I'm going out on a limb here but: if you design a good super-regulator, that's robust and well-staffed, can't you have multiple viewpoints? That can happen within an agency, hard as it may be to believe.

Or, like Bair, you can just believe in having many regulatory agencies to preserve the diverse viewpoints. Following that line of thinking, I think we should break up the FDA into the Food Administration and the Drug Administration. Further, let's break the Food Administration into food groups, to gather in as many viewpoints as possible. For instance, let's have a Vegetable Administration and a Fruit Administration.

Then we can let the tomato growers decide whether to lobby for regulation by the Vegetable Administration or the Fruit Administration.

That's called "regulator shopping," by the way. And guess what? It's something that's encouraged when you have these multiple regulators that Bair seems so fond of. Countrywide, at the epicenter of the subprime loan crisis, did exactly that kind of regulator shopping as exposed in this excellent Washington Post article. "Regulator shopping" gives regulators perverse incentives to be more lenient on their supervised entities, as that way they can attract more regulatees and grow their budgets.

Sounds pretty bad. So, going back to her op-ed, what would Bair suggest we do about this clear problem with multiple regulators?

Hmm ... nothing in there ... imagine that.