C is for Conflict of Interest

The financial blogosphere has been buzzier than normal in the past few days, because lots of people have strong opinions on the "good bank/bad bank" dilemma. For some of the best commentary, please visit sha, ka-shaw, and she-bangs. Geithner, Obama, and Berkanke have been the recipients of many open letters in the past few weeks. They must be quite busy.



My contribution to the cacophany will center on the raging conflicts of interest that nearly everyone involved in the process has. Politicians have constituents and economists have theories. Fine. Politicians may be popular or unpopular and economists can be right or wrong. Ultimately, their incentive structure is complicated and mostly based on reputation. In essence, they want to get it right.

But the ethical conflicts can be more sinister when investors, bankers, and businessmen are involved. Not because these folks are inherently more sinister, mind you, but because of what they do. They have "books" of investments and balance sheets. To oversimplify things, investments and balance sheets are agglomerations of bets made by individuals or companies that certain products are going to be worth more (or less, if you're a short seller) at a later date. If I'm T-Boone Pickens, and I invest $10 billion in natural gas, wind power, and solar energy with the expectation that these things will be worth more down the road, and Kieran the Genius Inventor(TM) discovers easily usable Cold Fusion tomorrow, you're SOL on your $10 billion. Tough luck, your wind power services are no longer needed here.

So when T-Boone is making the big bets on natural gas and wind power, you have to take his suggestions on energy solutions with a grain of salt. That doesn't mean T-Boone's wrong, it just means he has a strong financial incentive to give you a one-sided argument about what needs to be done.

Back to good bank/bad bank. By definition, many experts in finance either work for, or have worked for, major financial institutions. By definition, many of these same people have made big bets on what happens with these toxic assets. Some are long, some are short, but few are truly impartial.

Let's use a poker analogy. Everyone's got a hand. Some have good hands (flush - hedge fund manager, straight - economist, two pair - business exec), some have bad hands (seven high - wage laborer) and the banker, well, the banker is playing its hand based on a complicated model that says in any given hand, only a certain fraction of hands default (lose). It purchased these hands in packages of 10,000, so it doesn't actually know what cards it has this hand, but its model says that this is a triple AAA-rated hand and has a 97% chance of winning.

In poker, the rules are simple: person with the best hand wins. That's usually the case in investing, too. You invest in asset A. If its value goes up, you pocket the difference between the price at which you purchased the asset and the price at which you sold it. Here, banks are trying to convince the US government that it has a hand that is better than everyone else thinks it has, but that because of the nature of the economic environment (they sprung for too much beer and nachos and have no "liquidity"), they cannot turn their hand over to show how great their hand is. If they had liquidity to hold on to their hand for say, ten to fifteen years, they argue, it would be clear that they have the winning hand. But they can't. So they want to arrange a deal where they can sell their "winning hand" to the dealer. The banks claim they are entitled to 97% of the entire pot, because their hand is that good. S&P (who just so happens to be the bank's cousin and roommate) thinks they should get 87% of the pot. The other players either think they should get nothing (don't they know the rules? No show, no money!) or a tiny fraction of the pot commesurate with the unlikely possibility that they're actually holding the best hand.

Now, this analogy is only slightly more absurd than what is happening today. If this were Vegas, Mr. Banker would be 86ed from the casino. The only problem is that the banks have wagered so much money on this hand, that their hand can actually bankrupt the whole casino. This means that there's a real chance that nobody's going to win this hand. So everyone gets in an argument about what should be done. Banks have one opinion, the other players have their own opinion, and then there's a whole host of expert poker player/casino operators offering their own resolutions. It's quite the pickle. To complicate matters, most of the experts in the field are playing in the game, so it's hard to know whom to trust. Everyone wants to be right, and everyone wants to be vindicated. But much of the chatter comes from folks who may win or lose large amounts of cash based on what's decided (Bill Gross, anyone?).

Now, let's return to real life. Bankers have assets on their books that are destroying their capital positions, and this is in turn impacting the stability of the whole system. Most agree that something must be done, but there is little consensus as to what.

As was the case for our poker game, most of the experts in the field are playing in the game, so it's hard to know whom to trust. For example, John Paulson, brilliant investor guy, has been long and short these mortgage products, and will likely make money on both ends. Having him involved in the discussion would be enormously helpful to Geithner et al, because he's one of the few people who has a demonstrated record of competence with them. (Note: I don't believe that John Paulson -- who is not related to former Treasury Secretary Henry Paulson -- has expressed any interest in participating in this conversation, which is probably our loss.) But if he's involved in the discussion, he'll have a conflict of interest. Should we exclude him from the conversation?

I say no. But, since this is a public debate that will determine where public money will be spent, we need to know who has Geithner and Obama's ear. Already, there are whispers that Goldman Sachs and other banks have been part of the team crafting the proposal. I don't know if this is true, but it's a scary thought, knowing that taxpayer money is going to be used based on proposals by folks who have stake in the game. Unfortunately, it's probably unavoidable.

For that reason, transparency is essential. To effectuate this, here are my three simple suggestions.

1) All meetings and discussions about when and where taxpayer money will be used to pay off private debt should be a matter of public record. The public record about these meetings should detail who attended the meetings, what they said, and what conclusions were made.

2) All government employees involved in the decision-making process should have their employment history and financial holdings with any entity receiving access to these funds disclosed.

3) Any private investor whose opinion is considered in the discussion must disclose any significant position (threshold $1 million) that could be impacted by these decisions, including, but not limited to, disclosure of potential losses in the event of an adverse decision.

The Paulson meeting with bank CEOs last fall where he wrote $25 billion dollar checks without any record did not engender confidence. It breeds conspiracy theories and distrust about the process. While I believe that Paulson believed he was doing what was right, because of the money involved and the potential conflicts of interest, we have to be more open. We know that the bailout will be unfair. For the rest of us, a card laid is a card played. If you're big enough, you call your buddy in the treasurer's office and renogatiate the rules. Most of us have accepted these things. We know that it will cost taxpayers money and opportunities. But if we have full transparency, we will have an easier time eliminating the most obvious and dangerous conflicts of interest.

That's all I have to say about that.