04 November 2008

Betting on Too Big To Fail

As I've said before, one problem with the politicization of the recent fun and games on Wall Street has been that no one's interested in answering the really interesting and important question, "How come the market seems to have been systematically underpricing risk for years?"

Tom Maguire, who's almost as good on this question as he was on Plame, points us to a partial answer on the part of one big player.


Harry Eagar said...

AIG was a bucket shop. The whole street, worldwide, was a bucket shop.

$55 trillion in credit default swaps (that we know about). There are just barely $55T in tangible assets in the whole world, maybe.

Asking about AIG's risk assessment is beside the point. Do crapshooters make risk assessments? Hedge their come?


Nobody who has ever dealt with a crook fails to understand what was going on. What did surprise me was that muni bonds were being turned into derivative contracts. (Well, not where I live. The New Dealers made it illegal, so the promoters never even knocked on our doors.)

You guys just wait till the munis start defaulting. And the municipalities start laying off their teachers, sewer repairmen etc. Who will default on their (not subprime or alt-A) mortgages.

Which will drive down housing more, leading to more defaults.

(This last is a precis of a talk I had with an academic who specializes in financial markets today. He says it reminds him of the S&L collapse in the mid-'80s, except that one didn't 'leak' into the general markets.)

Ain't it great how unsupervised markets work? It's like magic.

Don't say I didn't warn ya.

David said...

AIG wasn't a bucket shop because it wasn't a brokerage. AIG insured derivative trades. The point is that it priced its insurance only in terms of the risk of a particular idea and without including the risk that the whole market would go south, presenting it with a massive bill at once and draining all its liquidity.

In fact, that's what happened.

I assume that complaining about the unregulated municipal bond market was just a joke.

joe shropshire said...

This is what a real bucket shop looks like. The keynote speaker is an especially nice touch.

Harry Eagar said...

Joe, I guess you are too young to know what a bucket shop is. Thank FDR for that, too.

The municipal bonds are regulated, but the credit-default swaps of them wasn't (except in Hawaii and like jurisdictions).

And your description of what AIG did was exactly what a bucket shop does: It takes in deposits and promises to repay at a market rate in the future, but it doesn't do anything with the money except hope the market goes down.

If you detect a logical contradiction in that with a scam based on ever-rising markets, you're right.

Ponzi schemes don't last forever.

jim hamlen said...

Speaking of too big to fail, the next big thing will be when public pension funds begin to crash (see San Diego for an early harbinger).

I don't know the citation, but the Supreme Court apparently ruled in the early 60s that public pensions are "contracts" and must be paid as 'stipulated' (by whatever applicable document).

What taxpayer is going to want to pony up the difference between the fund in Sept. 2007 and the fund in Sept. 2008? What municipal worker is going to want to see the numbers on how rotten his pension suddenly turned? And what politician has the guts and brains to even study the issue? And what is Andy Stern's opinion on public workers having to extend their 'nominal' retirement age to well past 60?

Note - a trial starts in San Diego (this month, I believe) for the officials involved, although no politicians (as I recall).

Harry Eagar said...

Yes, I get a daily report about this supposed scandal. What the report fails to mention is the private funds that went bust, despite ERISA, which supposedly makes business managers personally liable for shortages.

Now there's an example of regulation that has not worked.

I note, without amusement, that people who flog this issue (eg, Glenn Reynolds) never, ever suggest that the problems with private funds are as bad and worse.

One suspects ideology is at work, rather than sober financial analysis.

jim hamlen said...

Harry, aren't the laws concerning "private" pension funds much stricter than any 'regulation' on public funds? Just like the accounting practices in business are much tighter than those for the government, which, after all, writes its own rules as it goes along. The private funds that have gone bust in the past few years (airlines, trucking, etc.) have all been quite well documented, and their problems have little to do with the company filching the pot.

George Miller held hearings in August to consider the government takeover of the 401(k) system. No matter what his guru economist is promising, that is outright theft, no?

And hasn't CALPERS made some dodgy changes to the way its board is run? It has also resisted political accountability, to the point of publicly fighting with Arnold.

From the small towns to the mega-funds, this is a coming earthquake. And just like Fannie, Freddie, and Bear Stearns, the warning bells have been ringing for a long time. Reynolds flogs it because nobody in the media even understands the issue. Has your paper ever written about it?

Harry Eagar said...

My paper would be me, and I haven't had time or occasion to write about it. Our county system (which is folded into the state system) is adequately funded. One result of having a Legislature beholden to public sector unions.

I am so old that I did write about ERISA when it was being passed. A monstrosity of regulation if there ever was one.

Regulation was unquestionably needed, but a combination of factors (I blame primarily business resistance) prevented a proper regulation's being drafted.

It may be the biggest regulation ever written, and even the people who wrote it admitted that nobody understood it.

ERISA certainly offered plenty of opportunity for shysters, and if you poke into some of the failed plans, I think you will find that they were looted under the pretext of having been overfunded.

Funny thing about marking to market in up markets.

The defined plan I'm in used to be 'overfunded,' then a big slug of cash was taken out when the corporation hit the skids.

I have my doubts about whether it's adequately funded now, but I don't care because I have no plans ever to collect from it.

jim hamlen said...

Joe - I just checked your link. Nice touch.

BTW, did anyone else read about Rahm Emanuel's first job after leaving the White House? It was the board of Fannie, no less (no doubt at the recommendation of Raines and/or Johnson). What would Schumer say if this were an incoming Republican administration?

Yes, ERISA is hopeless. But the real issue is the massive tax hit municipalities are looking at to fund their retirement systems. And who will pay in places like Detroit (for example), where there is no tax base left?

Harry Eagar said...

Who will pay in Detroit? The state will take over, I'm guessing.

And very likely, the price for the retirees will be a negotiated reduction in the payout.

jim hamlen said...

Well, I suppose Granholm might propose paying for Detroit's retirement system, but I doubt if the rest of the state would go along. They could go to D.C., but they will have to get in line.

But the idea of 'reducing' pension payments is precisely what this discussion is about - from what I understand, if the benefits are part of a negotiated contract, they cannot simply be 'reduced' (for public employees).

Corporations can fail (for a multitude of reasons), and their pension plans can evaporate, but not so with public employee pensions. The tsunami is coming.

David said...

ERISA is actually an excellent law.

Also, unless you guys know the difference between a defined benefit plan and a defined contribution plan, this discussion isn't going to get far.

The real problem with public pensions is not pension law or management, but politicians giving the store away to public employee unions. If you want sensible and affordable local and state government, remove the right to organize from public employees. We're not going to get sensible government otherwise.

Harry Eagar said...

I know the difference.

I understand the concept behind ERISA, and, as with most government regulations, it was imposed to answer a real need, but the idea that putting their personal assets at risk would lead private company managers to prudently manage pension programs hasn't worked.

Jim's notion that pension contracts cannot be unilaterally abrogated is cute. It happens every day, Jim.

jim hamlen said...


Surely you know that ERISA does not apply to "public" employees.

When was the last time a public employee pension fund went bust?

For a very recent article, see here: http://www.tdn.com/articles/2004/07/31/oregon/news03.txt

In just 5 or 10 minutes time, I learned that NY modified its State Constitution in 1938 to define pension agreements as contracts. When the state attempted to use the money in 1991 (to help with a budget crunch), a huge fight ensued.

The same happened in Oregon in 1994, when Measure 8 was passed to limit the ability of the state on payouts - the State Supreme Court threw it out. And (from the article I mentioned), there is a fight over state employees who are now getting pensions that are twice their salaries when they worked. It looks like the State Court may allow that to continue as well. But their fund is $17 billion the hole - and who would expect the Court to do anything other than force tax increases to fill the "bucket"?

I suspect Harry's disgust towards ERISA is based on the special circumstances that affect Hawaii. According to what I read, Hawaii needs Congressional approval before changing its pension laws (due to the changes that were made in 1973/4, just before ERISA was passed).

I don't understand why someone so suspicious of corporate motives and actions is so blissfully satisfied with government motives and actions. After all, the word 'corporate' is not only synonymous with business.

Harry Eagar said...

My disappointment with the Employees Retirement Security Act is that it failed to secure the retirement income of employees.

Simple as that.

I have never said anything good about public pensions, I just wondered why the people who attack underfunded pensions look at only one kind -- and not the biggest kind, either.

I suspect ideological, rather than actuarial, motives.

jim hamlen said...

Come on - the reason Reynolds writes about public pensions is because taxpayers are on the hook for them. And all kinds of governments (state & local) have juiced their pension guarantees beyond anything reasonable (as Oregon apparently has), either because they are afraid of their public unions or because they are ensuring their votes (or both).

Ideology plays a role, perhaps, but wouldn't a desire for good government lead anyone to conclude that retiring at 56 or 58 with a higher pension than the salary that one earned is just crazy?

This isn't France. But many states and municipalities may soon be enjoying the experience.

Reynolds had a link today to a story about IL, where the state pension fund is supposedly at 56% of where it needs to be (by law or just actuarial sense, I don't know). Anything under 75% is considered severe. They can't reduce payouts, so the question becomes - how high can the taxpayers jump?

Anonymous said...

"I just wondered why the people who attack underfunded pensions look at only one kind"

Because other kinds of pension funds don't have people with guns who can re-fund the pension from my personal wealth, that's why.

David said...

Harry: You're just wrong about ERISA which, among many other things, set up PBGT which secures the retirement income of employees.

Harry Eagar said...

Yeah, right. While Reynolds is worrying about public pension funds that may someday go sour, there are people actually getting stiffed in the private sector and not a word about that.

'PLAINVIEW, NY (MMD Newswire) November 10, 2008 - - Americans who thought their money was safely put away in traditional pension plans are now faced with possibly receiving only 50% of their money or nothing at all. Due to the loss in the
market, a new pension law called Adjusted Funding Target Attainment Percentage or AFTAP may be preventing pension distributions to retirees and those who need their pension to pay bills. The new restrictions, which became effective in 2008, were
enacted as part of The Pension Protection Act of 2006.

' "The law is designed to protect employees in under-funded pension plans. However with the stock market down over 30% since its high in October 2007, many pension plans are now
significantly under-funded," explains Brett Goldstein, a Plainview, New York-based pension administrator and President of The Pension Department. He continues, "The new law is intended to shore up pension plans and put an end to under funded pension plans. However, in a time of financial crisis the law is actually hurting employees who are relying on their pension as their sole source of income at retirement. Retirees getting only 50% of what they were promised, or no
pension check at all, are going to have a hard time making ends meet. It also hurts employees who are getting laid off due to corporate downsizing and are relying on their pension to pay bills while they look for a job." '

jim hamlen said...

Your excerpt does not explain how the new law "hurts" employees just because the market is down 30%, it baldly asserts that pensions may be reduced 50% (or even 100%). Why? Sure, we know that the companies may raid the funds, or the directors may dump the whole thing in the government's lap. But the excerpt doesn't explain anything.

And saying that retirees getting 50% or nothing at all are going to have a hard time making ends meet is like saying water is wet.

Actually, this reminds me of the Enron folks who put all their defined contributions into Enron stock. Of course, in their case(s), they were responsible for checking that box off every year.

Somebody whose defined benefit plan goes bust is in a different boat. But why should anyone at GM today expect to be treated better than workers from US Steel 25 years ago? Or the employees at Lehman, whose 401(k)s certainly evaporated?

Moreover, the Argentine solution is a bit dramatic, don't you think?

Harry Eagar said...

So you admit workers in the private sector got stiffed 25 years ago. That was since ERISA, which is about 30 years old. (I forget how old, but I was young when I wrote about it.)

Anyhow, tens, maybe hundreds of thousands of workers get their pensions cut or eliminated every year, by private business, and it isn't even worth a mention.

Why is that?

jim hamlen said...

Sure, 'private' pensions fail (or are turned over to other management). But for companies with enough employees, they most likely get some relief from the PBGT, as the airlines did. Companies with 500 employees and down are all 401(k) now, I would think. Or something else that is not strictly a defined benefit plan. I don't know what workers at small firms would have received 30 years ago (union pensions? perhaps a lump sum?).

But the reason it is not BIG news is because I am not taxed to pay full retirement benefits to said employees, no matter how their fund is managed. Is that so hard to understand?

I also doubt if the number of workers having their pensions "eliminated" is that high. Hundreds of thousands a year would be BIG news. Fifty thousand a year would not be, especially if the workers are still working (and their benefit plan merely was changed). It would be much worse, of course, for the retirees themselves.

But again, the public employee unions have way too much clout on this point. I sure would like to be able to scream a bit, and sue a bit, and watch the state capitol tremble and hand me more than I earned when I was working.

BTW, ERISA passed in 1974.

Harry Eagar said...

You can doubt it all you want, but it's true all the same.

It was hundreds of thousands in airlines alone over a period of 3 or 4 years.

jim hamlen said...

Based on a few minutes googling around, I think the number since 9/11 is about 120,000 airline jobs eliminated (with 20,000 of that in 2008).

But, how many of those were employees expecting full pensions? The airlines are very seniority conscious, and employees hired since, say 1998, weren't really oriented towards retirement, anyway. The 'hardest' hits would be on high wage employees who have to endure reduced payouts. But I don't think their pensions just disappeared.

And you still haven't explained how losing a job means losing a pension. The PBGC website says they 'guarantee' 44 million pensions. That's probably fluff, but it ain't chicken feed, either. Whether or not they can continue to insure that many, and at what level, is probably murky.

But the point of this discussion is that there are millions of public employees who stand to retire at 55, 58, or even 60 with untouchable pensions, and the combination of demographics, urban politics, and judicial activism has put that money above almost every other fiscal priority in state and local government. Is that sustainable? Is it desirable?

Harry Eagar said...

That's just the jobs eliminated. Gotta count the already-retireds who lost their retirement in the bankruptcies.

I was being careful. The total is probably in the millions and maybe even ten million.