The Stone City

Words Made to Last

Thursday, January 31, 2008

The Pet

John McCain will never be President. Although he is increasingly likely to win the Republican nomination for President, he has essentially no chance of prevailing in the general election. Here we review the reasons why.

First, Mr. McCain's status as the media's Pet Conservative will end abruptly as soon as he faces a Democrat in a competitive race. Alex Whitlock and I explored this point back in 2005. Mr. McCain's hawkish and conservative stances right now are a silent majority, since he attracts attention only for his deviations from the party line. But a closer look, especially one guided by a well-funded opponent, would show him as the harshest sort of authoritarian conservative. Mr. McCain would run well to the right of Mitt Romney in a general election -- not by choice, but because his opponent and the press would put him there.
An inevitable consequence of this is that the tailwind of steadily favorable press coverage, which has largely propelled Mr. McCain to this point, would reverse. The press has no love for hawkish, name-calling conservatives when they are not opposing other Republicans. Its coverage of Mr. McCain would be unremittingly negative, reversing the "maverick" image he has enjoyed to date. He will be portrayed as a cranky, right-wing authoritarian, which is two-thirds correct.

As partial payment to McCain for supplying them with a stream of "maverick" stories, the press has so far refrained from excavating his closet. This also will not last. Oh, look: Charles Keating! And something tacky...

Having digested this picture, which will be on steady display from the moment McCain clinches the Republican nomination, America's legions of Hillary Clinton haters will march into the polling booths, check that the doors are securely closed, throw up in their mouths a little, and pull the lever -- for Hillary Clinton.

If Mr. McCain is obliged to run against Barack Obama, his situation will be far worse. Mr. Obama may be a party-line liberal, but he seldom ventures further to the left, so he will have an easy task positioning himself as the centrist candidate. Even attacks on his plans for the overwhelming boondoggle of nationalized health care will fall flat: he will simply announce his intention to "carefully investigate options" to see which are "affordable and fair", and Mr. McCain will look like the doctrinaire extremist who isn't even willing to investigate. Others have already made the point about how a debate between these two candidates will look.

John McCain sincerely believes he is his own man. And, as a Senator from Arizona, he is. As a candidate for President, he is the media's creation; and what they have built, they can surely destroy.

[Hat tip: Glenn Reynolds. Cross-posted to Chequer-Board.]

Wednesday, January 30, 2008

Rewarding Failure

The collapse in 2001 of Enron's long-running pyramid scheme was, at heart, an accounting scandal. Enron's own accountants were captive to corruption at the top, and external auditors -- whose whole raison d'etre is to produce a true record of financial activity without relying on the honesty of the in-house staff -- failed to detect any problem. Accountancy, as a whole, could not deliver what people expected of it.

The legislative response to Enron's fraud was driven by an irresistible imperative to take some action, and constrained by refusal to reevaluate the premises of the existing system. The result, predictably enough, was to double down on a failure: Congress, especially with the Sarbanes-Oxley act, has sought to address this problem by massively increasing the power of accountants and auditors, and increasing each corporation's reliance on them.

Consider the 2007 credit market turmoil in this light. This problem is, at heart, a rating-agency failure; it is worth understanding this in some detail.

Ratings are important to most institutional investors because of regulatory restrictions on ownership: mutual funds, for example, cannot own "junk" (BB/Ba or lower rated) bonds. But investors tend to seek the highest yield, or equivalently, the lowest price for a bond paying a given coupon. The business of structured credit finance, in the presence of these regulation-induced incentives, becomes a search for products which are attractive to the rating agencies but unattractive to buyers, thus combining high ratings with high yields. Investment banks create such products by bundling low-priced bonds together, then selling claims on part of the resulting bundle. This can degenerate into a contest to best game the rating agencies' models; the existence in early 2006 of AAA-rated paper paying 500 basis points above Libor indicates that such gaming, if it was undertaken, succeeded.

The rating-agency model has proved inadequate for credit risk management, and it cannot be rescued. If ratings agencies are involved in trading, they cannot retain the trust of investors or of regulators; without trading revenue, they cannot keep pace with the modelling capabilities of investment banks or of hedge funds.

Now we turn to the government response. Again impelled to do something, and again unwilling to reexamine their premises, our government is preparing "reforms" which will increase the power of the rating agencies, and the financial system's dependence on them. The government is preparing to force the banks to bail out the monoline insurers, so that debt of questionable quality but insured can continue to be rated AAA, and thus can continue to be used to meet government-imposed regulatory capital requirements. This will still further entrench the ratings-driven system, just when it has manifestly failed.

[Cross-posted to Chequer-Board.]