Besides Failing Corporate Finance 101, Holtz-Eakin's Attack on Dodd-Frank Sets a Terrible Priority

May 8, 2015Mike Konczal

The American Action Forum jumps into the financial reform debate with a letter on the growth consequences of Dodd-Frank penned by its president, Douglas Holtz-Eakin. This letter is a bad analysis, immediately violating the first thing you learn in corporate finance: capital structure doesn’t dictate funding costs. But there’s a deeper context that makes this letter reckless and a bad development, and I hope they are willing to walk back part of it.

Why reckless? It’s important to understand the role people like Holtz-Eakin play in the conservative movement. It is less about providing analysis (which is good, because this is a bad analysis), and more about signaling priorities. What should be done about Dodd-Frank if the Republicans win in 2016? This letter signals a new front I haven’t seen before on the right: one focused on going after higher capital requirements. Worse, going after them as if they were, using that conservative trigger word, a “tax.” I think that is a terrible move with serious consequences, and if they are going to do it, they need to do better than this.

A Bad Analysis

Americans for Financial Reform and David Dayen give us a solid overview of what is lacking in this analysis. It contains no benefits, confuses one-time and ongoing costs, assumes all costs derive from the cost of capital rather than profits, and so on. I’m also pretty sure there’s an error in the calculations, which would reduce the estimate by a third; I’m waiting for a response from them on that [1].

But I want to focus on capital requirements. Holtz-Eakin argues that the Solow growth model “can be used to transform the roughly 2 percentage point rise in the leverage ratio of the banking sector” into “a rise in the effective tax rate.” Wait, the tax rate? “The banking sector responded to Dodd-Frank by holding more equity capital,” writes Holtz-Eakin, “thus require it to have greater earnings to meet the market rate of return – the same impact as raising taxes.” Higher capital requirements, in this argument, function just like a tax.

He concludes that a 2 percentage point rise in capital requirements, much like what we just had, increases the cost of capital somewhere between 2 and 2.5 percent. (I believe I understand that to be the argument, though the paper itself is quick and not cited to any body of research.)

This is wrong, full stop. The Holtz-Eakin argument is predicated on the idea that capital structure directly affects funding costs. But our baseline assumption should be that there is virtually no impact of capital requirements on cost of capital. Economics long ago debunked the notion that changes in aggregate funding mixes can have an effect on the value of a business itself, much less a widespread, durable, macroeconomic effect. This is a theorem they teach you in Corporate Finance 101: the Modigliani–Miller theorem. And this has been one of the most important arguments in financial reform, with Anat Admati being a particularly influential advocate of pointing this out.

Just step back and think about what Holtz-Eakin’s model means. If Congress passed a law requiring companies to fund themselves with half as much equity as they did before, would the economy experience a giant growth spurt from changing the aggregate funding mix? No, of course not. The price of capital would simply adjust with this new balance; funding with more equity means funding with less debt, though the business is still the same. Investors are not stupid; they respond to a changing funding mix by simply changing the prices accordingly. This is how markets are supposed to work.

Of course, the real world doesn’t work exactly like these abstract economic models. If there’s a hierarchy of financing options, which seems reasonable, then moving up or down that ladder can impose some costs. Doug Elliott from Brookings, for instance, writes quite a bit arguing that the idea that equity and higher capital requirement is costless is a dangerous “myth” of financial reform. (Here is Admati responding.)

So Elliott’s not on the costless side, but does he agree with Holtz-Eakin’s numbers? Not even remotely. According to Elliott’s estimate, the cost of the entirety of Dodd-Frank increases the cost of capital 0.28 percent, and the “low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs.”

As shown in the graphic above, a model of higher capital requirements by Kashyap, Stein, and Hanson put the estimate of a 2 percent capital increase at between 0.05 percent (driven by the tax effects) and 0.09 percent (driven by a large slippage of Modigliani-Miller they assume to get a high-end estimate). These are broadly in line with other estimates throughout the past several years. Even the most industry-driven estimates designed to weaken capital requirements don't remotely approach this 2.00+ percent increase.

(As a coincidence, Elliott did estimate what it would take to make the cost of capital rise Holtz-Eakin’s estimated 2 percent. In his view, it would be capital requirements on the order of 30 percent, which is the reach goal for some. But when you analyze Dodd-Frank and get numbers consistent with 30 percent capital ratios, you are probably doing it wrong.)

A Worse Priority

So the estimate is wrong in a fundamental way; but this is less about a specific analysis than it is about setting priorities for the conservative movement when it comes to Dodd-Frank. And if attacking capital requirements becomes a major priority for conservatives, that’s a worrying sign. When conservatives start calling things “taxes,” institutional forces go into play beyond the control of any specific person, and that’s dangerous for a successful reform with lots of support that is important for a better financial system.

A broad group of people has come together to argue for capital requirements. This includes important commentators across the spectrum, from Simon Johnson to John Cochrane to many others. And there’s good reason for this. The current capital requirement regime hits six birds with one stone: helping with solvency, balancing risk management, making resolution and the ending of Too Big to Fail more credible, preventing liquidity crises in shadow banking, right-sizing the scale and scope of the largest financial institutions, and macroeconomic prudential policy.

There are disagreements about specifics of what is the best way to do higher capital requirements—quite intense ones, actually. But there’s a broad consensus in favor of them. Having watched this from the beginning, this broad coalition is one of the most promising developments I’ve seen.

I’m excited to see the right go after Dodd-Frank. Is the argument that there’s too much accountability for consumers now, and we need to gut those regulators at the CFPB? Is it that derivatives regulations are too extensive, and we should build our future prosperity by letting a thousand AIGs bloom? Is it that there should be few, if any, consequences for firms that break the law or commit fraud? (As someone who is worried about over-policing, this is one area where I believe we are criminally under-policed.) Please, by all means, make these arguments.

But taking on capital requirements with this weak argument is a bad development. The financial market is not understudied, and though nobody has ever found anything like these results, and though it's clear Holtz-Eakin’s analysis doesn’t even engage with this other research, those who think the cost of capital requirements are low could be wrong. But to prove that, we’ll need an analysis far better than the one provided here. And until one has that, the responsible thing is to not unleash the conservative movement against reform that is doing good work and that should be advanced rather than dismantled.

 

[1] I’m pretty sure for “rL-C” in equation 11 he uses net income ($151.2bn) rather than EBIT ($218.7bn), though, from equation 9, “rL-C” should be pre-tax. However using the wrong number is the only way I can replicate the estimate he has. I’ll update this either way if they respond.

If I’m right this decreases Holtz-Eakins’ growth costs of regulations by about 30%, meaning that the economy will probably be skyrocketing any second now.

Follow or contact the Rortybomb blog:
 
  

 

The American Action Forum jumps into the financial reform debate with a letter on the growth consequences of Dodd-Frank penned by its president, Douglas Holtz-Eakin. This letter is a bad analysis, immediately violating the first thing you learn in corporate finance: capital structure doesn’t dictate funding costs. But there’s a deeper context that makes this letter reckless and a bad development, and I hope they are willing to walk back part of it.

Why reckless? It’s important to understand the role people like Holtz-Eakin play in the conservative movement. It is less about providing analysis (which is good, because this is a bad analysis), and more about signaling priorities. What should be done about Dodd-Frank if the Republicans win in 2016? This letter signals a new front I haven’t seen before on the right: one focused on going after higher capital requirements. Worse, going after them as if they were, using that conservative trigger word, a “tax.” I think that is a terrible move with serious consequences, and if they are going to do it, they need to do better than this.

A Bad Analysis

Americans for Financial Reform and David Dayen give us a solid overview of what is lacking in this analysis. It contains no benefits, confuses one-time and ongoing costs, assumes all costs derive from the cost of capital rather than profits, and so on. I’m also pretty sure there’s an error in the calculations, which would reduce the estimate by a third; I’m waiting for a response from them on that [1].

But I want to focus on capital requirements. Holtz-Eakin argues that the Solow growth model “can be used to transform the roughly 2 percentage point rise in the leverage ratio of the banking sector” into “a rise in the effective tax rate.” Wait, the tax rate? “The banking sector responded to Dodd-Frank by holding more equity capital,” writes Holtz-Eakin, “thus require it to have greater earnings to meet the market rate of return – the same impact as raising taxes.” Higher capital requirements, in this argument, function just like a tax.

He concludes that a 2 percentage point rise in capital requirements, much like what we just had, increases the cost of capital somewhere between 2 and 2.5 percent. (I believe I understand that to be the argument, though the paper itself is quick and not cited to any body of research.)

This is wrong, full stop. The Holtz-Eakin argument is predicated on the idea that capital structure directly affects funding costs. But our baseline assumption should be that there is virtually no impact of capital requirements on cost of capital. Economics long ago debunked the notion that changes in aggregate funding mixes can have an effect on the value of a business itself, much less a widespread, durable, macroeconomic effect. This is a theorem they teach you in Corporate Finance 101: the Modigliani–Miller theorem. And this has been one of the most important arguments in financial reform, with Anat Admati being a particularly influential advocate of pointing this out.

Just step back and think about what Holtz-Eakin’s model means. If Congress passed a law requiring companies to fund themselves with half as much equity as they did before, would the economy experience a giant growth spurt from changing the aggregate funding mix? No, of course not. The price of capital would simply adjust with this new balance; funding with more equity means funding with less debt, though the business is still the same. Investors are not stupid; they respond to a changing funding mix by simply changing the prices accordingly. This is how markets are supposed to work.

Of course, the real world doesn’t work exactly like these abstract economic models. If there’s a hierarchy of financing options, which seems reasonable, then moving up or down that ladder can impose some costs. Doug Elliott from Brookings, for instance, writes quite a bit arguing that the idea that equity and higher capital requirement is costless is a dangerous “myth” of financial reform. (Here is Admati responding.)

So Elliott’s not on the costless side, but does he agree with Holtz-Eakin’s numbers? Not even remotely. According to Elliott’s estimate, the cost of the entirety of Dodd-Frank increases the cost of capital 0.28 percent, and the “low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs.”

As shown in the graphic above, a model of higher capital requirements by Kashyap, Stein, and Hanson put the estimate of a 2 percent capital increase at between 0.05 percent (driven by the tax effects) and 0.09 percent (driven by a large slippage of Modigliani-Miller they assume to get a high-end estimate). These are broadly in line with other estimates throughout the past several years. Even the most industry-driven estimates designed to weaken capital requirements don't remotely approach this 2.00+ percent increase.

(As a coincidence, Elliott did estimate what it would take to make the cost of capital rise Holtz-Eakin’s estimated 2 percent. In his view, it would be capital requirements on the order of 30 percent, which is the reach goal for some. But when you analyze Dodd-Frank and get numbers consistent with 30 percent capital ratios, you are probably doing it wrong.)

A Worse Priority

So the estimate is wrong in a fundamental way; but this is less about a specific analysis than it is about setting priorities for the conservative movement when it comes to Dodd-Frank. And if attacking capital requirements becomes a major priority for conservatives, that’s a worrying sign. When conservatives start calling things “taxes,” institutional forces go into play beyond the control of any specific person, and that’s dangerous for a successful reform with lots of support that is important for a better financial system.

A broad group of people has come together to argue for capital requirements. This includes important commentators across the spectrum, from Simon Johnson to John Cochrane to many others. And there’s good reason for this. The current capital requirement regime hits six birds with one stone: helping with solvency, balancing risk management, making resolution and the ending of Too Big to Fail more credible, preventing liquidity crises in shadow banking, right-sizing the scale and scope of the largest financial institutions, and macroeconomic prudential policy.

There are disagreements about specifics of what is the best way to do higher capital requirements—quite intense ones, actually. But there’s a broad consensus in favor of them. Having watched this from the beginning, this broad coalition is one of the most promising developments I’ve seen.

I’m excited to see the right go after Dodd-Frank. Is the argument that there’s too much accountability for consumers now, and we need to gut those regulators at the CFPB? Is it that derivatives regulations are too extensive, and we should build our future prosperity by letting a thousand AIGs bloom? Is it that there should be few, if any, consequences for firms that break the law or commit fraud? (As someone who is worried about over-policing, this is one area where I believe we are criminally under-policed.) Please, by all means, make these arguments.

But taking on capital requirements with this weak argument is a bad development. The financial market is not understudied, and though nobody has ever found anything like these results, and though it's clear Holtz-Eakin’s analysis doesn’t even engage with this other research, those who think the cost of capital requirements are low could be wrong. But to prove that, we’ll need an analysis far better than the one provided here. And until one has that, the responsible thing is to not unleash the conservative movement against reform that is doing good work and that should be advanced rather than dismantled.

 

[1] I’m pretty sure for “rL-C” in equation 11 he uses net income ($151.2bn) rather than EBIT ($218.7bn), though, from equation 9, “rL-C” should be pre-tax. However using the wrong number is the only way I can replicate the estimate he has. I’ll update this either way if they respond.

If I’m right this decreases Holtz-Eakins’ growth costs of regulations by about 30%, meaning that the economy will probably be skyrocketing any second now.

Follow or contact the Rortybomb blog:
 
  

 

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Message to Mayor Emanuel: Play Hardball with Wall Street

May 6, 2015Saqib Bhatti

Last week, Mayor Rahm Emanuel announced that he plans to preemptively terminate a large portion of the City of Chicago’s remaining interest rate swaps, which will cost taxpayers $200 million in penalties. He is trying to sell this as a shrewd move that will protect Chicago from future risk and help return the city to financial health. Nothing could be further from the truth.

Last week, Mayor Rahm Emanuel announced that he plans to preemptively terminate a large portion of the City of Chicago’s remaining interest rate swaps, which will cost taxpayers $200 million in penalties. He is trying to sell this as a shrewd move that will protect Chicago from future risk and help return the city to financial health. Nothing could be further from the truth. In reality, this is little more than a capitulation to Wall Street that will guarantee maximum profits for banks at taxpayers’ expense. This is the moment for the mayor to play hardball and force the banks to take significant concessions to protect the interests of the city’s communities and its bondholders alike. He can do this by suing the banks for misrepresenting risks associated with these deals, in violation of their duty to deal fairly with municipal borrowers, and by initiating a debt strike against the swap counterparties by strategically defaulting on the swap payments.

Emanuel’s decision to pay the banks the full face value of the swap penalties is indefensible. When the termination clauses on Detroit’s swaps were triggered, a federal judge pushed the city to drive a hard bargain with the banks and forced them to take a 75 percent haircut on the penalties. The judge made clear that he believed the city had a strong argument to declare the swaps invalid and said the city would be “reasonably likely” to prevail if it took legal action to get out of the deals. The judge encouraged the city to stop making payments on the swaps and to sue the banks instead. As a result of these negotiations, the city paid just $85 million in penalties instead of $347 million.

Emanuel similarly has a strong argument that the banks that sold toxic swaps to both the City of Chicago and Chicago Public Schools (CPS) did so illegally, and he should use both the legal and financial options at his disposal to get a better deal from the banks. Instead of giving away $200 million to banks, the mayor should launch a debt strike against the swap counterparties. He should refuse to pay them another dime on the city and school district’s swaps. Corporations often use this tactic, which they call a debt moratorium, to increase their leverage in negotiations with creditors. Emanuel should also sue the banks to recover $1.3 billion in past and future payments on these deals. This would give the city and CPS tremendous leverage to extract major concessions from the banks and renegotiate these toxic deals.

The course that Emanuel has instead chosen, to preemptively pay the banks $200 million in penalties to terminate the swaps, will actually serve to maximize taxpayer losses rather than save the city money. The penalties are calculated based on the interest rate environment, and because variable interest rates are still at record lows, it means that paying the banks now guarantees that the city will pay a higher amount than if it has to terminate the swaps later. There is a growing consensus that the Federal Reserve will start raising interest rates soon, which will drive these penalties down. Now is the worst possible time to voluntarily pay these penalties, especially because the mayor actually has a lot of leverage to get a better deal for Chicagoans, if he chooses to exercise it.

Playing Hardball with Wall Street

The amount of the termination penalties is not set in stone. When a swap termination event occurs, municipal borrowers and banks typically enter into negotiations with each other, during which cities can use legal and financial leverage to get a better deal. The reality is that Chicago has a lot more leverage in these negotiations than its swap counterparties. For one, the city has a very strong legal argument that the banks that pitched its swap deals violated their legal duty to deal fairly with the city by downplaying and misrepresenting risks and failing to mention that many of them were rigging the interest rates that the swaps were based on. The city should take legal action to get out of these deals. But beyond that, the city also has tremendous financial leverage vis-à-vis the banks, because it could simply stop making its swap payments, which would actually free up money for the city’s residents, pensioners, and bondholders. In Detroit, a federal judge advocated both of these strategies, and the city was able to save $262 million on its termination penalties as a result.

Suing the Banks

When the City of Detroit was placed under an emergency manager in 2013 and then filed bankruptcy, it triggered termination clauses on its interest rate swaps, which came with hefty penalties that stood at $347 million according to the city’s bankruptcy filing. Through negotiations, the banks agreed to settle for just $250 million. The bankruptcy judge rejected this settlement, and urged the city to either negotiate a better deal or file a legal challenge against the swaps. The city and banks went back to the bargaining table and came back with an offer to settle for $165 million. The judge again rejected the proposal, saying that, “In the absence of this settlement, the city might pursue an underlying claim challenging the swaps themselves,” and adding that the city would be “reasonably likely” to be successful in such a challenge. Ultimately, the judge approved an $85 million settlement, a 75 percent discount on the original figure of $347 million.

This should be a lesson for Emanuel. Of course Detroit, unlike Chicago, got its swap termination penalties reduced during the course of bankruptcy proceedings. The judge’s legal rationale, however, was not tied to the specifics of the bankruptcy process. He believed the swaps themselves were likely invalid based on the facts of the underlying deals and that the city would have been on strong legal footing if it had stopped making payments altogether.

Similarly, Emanuel should challenge the legality of the city’s swap deals and those of CPS and use that legal leverage to try to get a better deal. Whereas Detroit was able to make the banks take a 75 percent haircut on its penalties, Emanuel is proposing to pay the banks 100 cents on the dollar. That is financially irresponsible.

Although city officials often worry that they will get cut off from the credit markets if they sue banks, these concerns are unfounded because the interests of bondholders and swap counterparties are actually at odds with each other. In Detroit, bondholders were actually advocating for the city to take an even harder line against the banks because the swap penalties would have left less money for the bondholders. Many of the city’s creditors objected even to the final $85 million settlement. In fact, taking legal action against the banks should theoretically improve Chicago’s standing among bondholders, because it would free up money for payments to bondholders.

Instead of preemptively paying Wall Street $200 million in penalties to terminate the swaps, Emanuel should sue the banks to recover nearly $800 million in past and future payments on the deals for the city and $500 million for CPS. The banks that pitched these deals like violated the fair dealing rule of the Municipal Securities Rulemaking Board by misrepresenting or omitting “the facts, risks, potential benefits, or other material information” with respect to these deals. Emanuel has several legal options at its disposal to recover that money, including filing a lawsuit in state court for breach of contract.

Launching a Debt Strike

In addition to suing the banks, Emanuel should also follow the Detroit bankruptcy judge’s advice and refuse to make any more payments on the swaps. The banks have little leverage to compel the city to pay. The worst they can do is terminate the swaps and demand the city pay $200 million in penalties, but since Emanuel already stands ready to pay them that, the city really doesn’t have much to lose. In fact, Emanuel should coordinate with the city’s other governmental units that also have interest rate swaps and launch a coordinated debt strike against their swap counterparties. Corporations routinely use this tactic, which they call a debt moratorium, to increase their leverage in negotiations with creditors and compel them to write down debt.

Chicago Public Schools is already facing more than $260 million in penalties because the termination clauses on its swaps have already been triggered. The city’s enterprise funds also have swaps tied to their debt that could carry penalties of more than $200 million if the funds’ ratings are downgraded. Between the city, its enterprise funds, and CPS, Emanuel controls more than $660 million that the banks want. This represents money that is pure profit for the banks—they have not lent the city or CPS any money against this amount. Instead, interest rate swaps are side deals that simply involve an interest rate exchange between two parties—an exchange that has turned into an unexpected windfall for banks as a result of the financial crash that they caused.

If Emanuel were simply to withhold this money, the banks would be at a loss. Banks cannot compel municipalities to file bankruptcy to try to recover this money (and in Illinois in particular, municipalities are not allowed to file bankruptcy anyway). They could seek a court order, but if Emanuel were also to take legal action against the banks, the judge could very well grant a stay on any payments until the court case was resolved, which could take years and would involve a discovery process that would likely be embarrassing for the banks. That would leave the banks with two options: strike a cheaper negotiated settlement like Detroit’s counterparties did, or risk an adverse court ruling through which they could actually be forced to pay back the city and CPS all the money they have already made on these deals—up to $1.3 billion.

Some may have concerns that strategically defaulting on the swaps would cause the city’s credit ratings to slide further. However, the city’s bonds are already trading at junk levels. Moreover, the rating agencies have already made clear that they intend to further downgrade Chicago’s credit rating anyway when the state’s blatantly unconstitutional “pension reform” bill is overturned by the Illinois Supreme Court. Ironically, a strategical default on  swap payments could actually improve the city’s credit rating, since it would free up more cash for payments to bondholders, as mentioned above.

The Termination Penalties Maximize Bank Profits

Instead of using the city’s leverage to drive a hard bargain with the banks, Emanuel is proposing to preemptively terminate the swaps and pay $200 million in penalties. The mayor’s contention that doing this will protect the city against future termination risk is illogical. In effect, his argument is that he is eliminating the risk that the city could be forced to pay banks $200 million in the future by paying them $200 million now. He isn’t eliminating the risk; he is realizing it by voluntarily signing a $200 million check to Wall Street. This may be proactive, but that’s cold comfort to the Chicagoans who need that $200 million to fund essential services in their communities like mental health clinics and libraries. This $200 million payment isn’t just bad for communities, it is also bad finance.

The standard interest rate swap contract has termination clauses built in. If any “termination events” take place, then the bank has the right to terminate the swap and collect termination penalties. These termination events include credit rating downgrades below a certain threshold, among other things. In the case of Chicago, further downgrades in the city’s credit rating could trigger termination clauses on the its swaps. Conversely, if a municipal borrower wishes to terminate a swap, it may do so at any time by paying the termination penalty to the bank. This is what Emanuel has decided to do.

These termination penalties are equal to the fair value of the swap at the time that it is terminated, which is calculated as the net present value of all future payments on the swap over its remaining life, based on the current interest rate curve. What that means is that these penalties guarantee the banks all of their future profits on the swaps. The standard way the penalties are calculated does not change regardless of which party terminates the swap or for what reason. Emanuel is not saving Chicago any money by terminating the swaps, but instead is simply choosing to absorb those losses now, so he can claim he was proactive.

In reality, the city is actually likely to save money if he waits. Variable interest rates have been stuck at historic lows since 2008, when the Federal Reserve slashed rates to near zero in response to the financial crisis. This has caused taxpayer payments on all traditional interest rate swaps in the country to balloon. Chicago now pays approximately $70 million a year on its swaps, and CPS pays another $36 million a year. Because the termination penalties represent future payments based on the current interest rate curve, this has also caused the penalties to skyrocket. As the Federal Reserve gradually increases interest rates, which it is widely expected to do, these penalties will come down. By paying the banks $200 million now, while rates are still at historic lows, Emanuel will guarantee that the banks get a larger payment than they would if the swaps were terminated six months or a year from now.

Furthermore, the mayor plans to issue new debt to pay off the $200 million. What that means is that Chicago taxpayers will also be stuck paying interest on this $200 million for the next 30 years or so. On traditional 30-year bonds, the interest ends up being roughly equal to the principal, which means these termination penalties could end up costing taxpayers around $400 million.

* * * *

Emanuel is trying to spin his decision to pay the banks $200 million to terminate the city’s swaps as a bold move that will save the city money in the long run. This is untrue. Paying the banks now would amount to little more than a handout to Wall Street that would maximize their profits at taxpayers’ expense. First of all, there is no financial benefit to paying the banks early since interest rates are expected to rise, which would cause the penalties to decline. Secondly and more importantly, the city has tremendous legal and financial leverage to get a better deal from the banks and could likely bring the $200 million penalty down to a fraction of itself if Emanuel played hardball. If he sued the banks, the city could win nearly $800 million in past and future payments and CPS could win $500 million. If he launched a debt strike against the swaps, the banks would have limited recourse. Instead of paying the banks $200 million in a feeble attempt to put the swap fiasco behind him, the mayor should take legal action against these toxic swaps and immediately cease all payments on these deals. That would be the bold thing to do.

For more bold solutions that Mayor Rahm Emanuel can pursue to bring new, progressive revenue into Chicago’s coffers, see the ReFund America Project’s report, Our Kind of Town: A Financial Plan that Puts Chicago’s Communities First.

Saqib Bhatti is a Roosevelt Institute Fellow and Director of the ReFund America Project.

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Senator Baldwin is Asking the SEC Questions About "Disgorge the Cash"

Apr 23, 2015Mike Konczal

A lot of people were surprised last month when the investment giant BlackRock flagged the rise in stock buybacks and dividend payments as a major economic concern. Its CEO argued that the “effects of the short-termist phenomenon are troubling both to those seeking to save for long-term goals such as retirement and for our broader economy,” and that this was being done at the expense of “innovation, skilled work forces or essential capital expenditures necessary to sustain long-term growth.”

They are right to be concerned. The cash handed back to shareholders in the form of buybacks and dividends was 95 percent of corporate profits in 2014, climbing from 88 percent the year before and 72 percent in 2010 and expected to go even higher in the future. These numbers are far above historical norms, but they are the culmination of a long process starting in the 1980s. Private investment remains a weak part of the recovery, and it is necessary to investigate the connection between corporate governance and those decisions.

With that in mind, Senator Tammy Baldwin (D-WI) has sent a letter to the SEC looking for answers on these issues. In particular, she flags whether the SEC’s mission to “foster capital formation and prevent fraud" is jeopardized by short-termism in the market. It will be good to see how the SEC responds, and which other senators and organizations join in with their concerns.

Personally, I’m happy that it quotes J.W. Mason’s work on profits and borrowing shifting from investment in a previous era to cash leaving the firm now. This issue is a major piece of our Financialization Project here at Roosevelt, and we will continue to develop it in the future.

I think there are two additional things of interest. One is that this relationship is becoming more of an interest for academic and popular scrutiny. Recent, high-level research is showing that as a result of short-termist pressures, “public firms invest substantially less and are less responsive to changes in investment opportunities, especially in industries in which stock prices are most sensitive to earnings news” compared to private firms before the Great Recession.

Second, this looks like a centerpiece agenda item for liberals going into 2016. Larry Summers’s Inclusive Prosperity report for the Center for American Progress discusses concerns over short-termism, noting, “it is essential that markets work in the public interest and for the long term rather than focusing only on short-term returns. Corporate governance issues, therefore, remain critical.”

The problem of short-termism was also in Senator Elizabeth Warren’s big speech on the future of the financial reform agenda, in which she noted we need to change the rules of the economy because we “too often reward short-term risk-taking instead of sustained, long-term growth” and allow CEOs to “manipulate prices in the short-term, rather than investing in the long-term health of their companies.”

And it will be central to work from the Roosevelt Institute about inequality coming next month. (Get excited!)

I’m not sure if the right has a response to this issue. One of their core policy goals, removing all taxes on capital, will certainly make the situation worse, as the Bush dividend tax cuts increased dividends payouts without encouraging any real investment or wage growth. If the Republicans want to have real answers about inequality and stagnation, it’s important that they tackle real questions. And short-termism is one of those essential questions.

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A lot of people were surprised last month when the investment giant BlackRock flagged the rise in stock buybacks and dividend payments as a major economic concern. Its CEO argued that the “effects of the short-termist phenomenon are troubling both to those seeking to save for long-term goals such as retirement and for our broader economy,” and that this was being done at the expense of “innovation, skilled work forces or essential capital expenditures necessary to sustain long-term growth.”

They are right to be concerned. The cash handed back to shareholders in the form of buybacks and dividends was 95 percent of corporate profits in 2014, climbing from 88 percent the year before and 72 percent in 2010 and expected to go even higher in the future. These numbers are far above historical norms, but they are the culmination of a long process starting in the 1980s. Private investment remains a weak part of the recovery, and it is necessary to investigate the connection between corporate governance and those decisions.

With that in mind, Senator Tammy Baldwin (D-WI) has sent a letter to the SEC looking for answers on these issues. In particular, she flags whether the SEC’s mission to “foster capital formation and prevent fraud" is jeopardized by short-termism in the market. It will be good to see how the SEC responds, and which other senators and organizations join in with their concerns.

Personally, I’m happy that it quotes J.W. Mason’s work on profits and borrowing shifting from investment in a previous era to cash leaving the firm now. This issue is a major piece of our Financialization Project here at Roosevelt, and we will continue to develop it in the future.

I think there are two additional things of interest. One is that this relationship is becoming more of an interest for academic and popular scrutiny. Recent, high-level research is showing that as a result of short-termist pressures, “public firms invest substantially less and are less responsive to changes in investment opportunities, especially in industries in which stock prices are most sensitive to earnings news” compared to private firms before the Great Recession.

Second, this looks like a centerpiece agenda item for liberals going into 2016. Larry Summers’s Inclusive Prosperity report for the Center for American Progress discusses concerns over short-termism, noting, “it is essential that markets work in the public interest and for the long term rather than focusing only on short-term returns. Corporate governance issues, therefore, remain critical.”

The problem of short-termism was also in Senator Elizabeth Warren’s big speech on the future of the financial reform agenda, in which she noted we need to change the rules of the economy because we “too often reward short-term risk-taking instead of sustained, long-term growth” and allow CEOs to “manipulate prices in the short-term, rather than investing in the long-term health of their companies.”

And it will be central to work from the Roosevelt Institute about inequality coming next month. (Get excited!)

I’m not sure if the right has a response to this issue. One of their core policy goals, removing all taxes on capital, will certainly make the situation worse, as the Bush dividend tax cuts increased dividends payouts without encouraging any real investment or wage growth. If the Republicans want to have real answers about inequality and stagnation, it’s important that they tackle real questions. And short-termism is one of those essential questions.

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Predatory Finance Has Hurt Our Universities, But Students Can Fight Back

Apr 13, 2015Dominic RusselRyan Thornton

Our tuition checks shouldn't be going to pay off debts from Wall Street's bad deals.

Our tuition checks shouldn't be going to pay off debts from Wall Street's bad deals.

The last few decades have not been kind to America’s local public institutions. Cities that once built state-of-the-art infrastructure are now struggling to fix potholes in the street. Public schools that were once the best in the world are lagging behind. Even our universities, which used to be gateways to a shot at a better life, are increasingly becoming too expensive for much of the population.

There’s no shortage of explanations for these problems, ranging from globalization to government waste to an aging population. These answers, however, all overlook the role that a growing Wall Street has played in changing the picture for public institutions.

In 1950, the financial sector accounted for about 3 percent of U.S. GDP; it now accounts for more than 6.5 percent. This financialization has given the big banks on Wall Street immense wealth and power, allowing them to extract greater and greater earnings from public and private borrowers. While the financial industry is reaping huge profits, it is individuals, not corporations, who pay an increasingly large share of the taxes that are supposed to support our public institutions. Since 1950, corporate tax contributions have dropped from 32 percent to only 17 percent despite corporations claiming a growing share of GDP. In contrast, individuals now pay 63 percent of taxes, up from 45 percent in 1950.

Our cities and schools—and all public institutions that rely on taxes to provide essential services—have felt the impact of this change. Facing slashed budgets, they have been forced to turn to the financial industry for loans. Undoubtedly, borrowing is necessary for financing extensive long-term capital projects; however, public institutions are increasingly compelled to secure loans for their short-term spending as well. Big banks are more than happy to accept the business of cities and universities desperate for funding, especially when the banks get to write the terms of the deal.

Wall Street’s profits are no longer solely built on interest from traditional “vanilla” loans. Instead, its banks have turned to high-risk, high-cost, and unnecessarily complex deals to further inflate their profits. Take interest rate swaps, for example. Swaps are a financial instrument devised by banks that allows cities and universities—those issuing bonds to finance long-term projects—to “swap” a variable interest rate for an agreed-upon fixed interest rate.

These interest rate swaps were deceptive from the very start. They were sold as protection from changing interest rates, but because exorbitant termination fees made refinancing extremely costly, they were essentially dangerous bets that would have only worked out if interest rates rose. And the deck was stacked against the cities and universities making these bets.

Banks illegally manipulated the London Interbank Offered Rate (LIBOR), which was tied to many deals, and helped precipitate a financial crisis that led to near-zero interest rates that continue today. Because banks had negotiated the swaps contracts so that they would be paying the variable market rates, cities and universities ultimately ended up locked into deals in which they were paying as much as 50 times what the banks were paying—all of which went to Wall Street as profit.

Both of the schools we attend—the University of Michigan and George Mason University—entered into swap deals that have costs them millions. One swap at Michigan even protected banks by allowing them to terminate the deal if variable rates hit just 7 percent, while offering no protection for the university when rates actually sank near zero.

The current imbalance in power need not be the case. Increased transparency surrounding the fees and terms of public finance deals would allow students and taxpayers to oversee the officials and banks who use their money and hold them accountable. When university regents, trustees, or other executives receive or have received compensation from the financial institutions their school does business with (as was the case in a series of University of California swaps), they should immediately recuse themselves from financial decision making to avoid conflicts of interest. Cities, states, and universities can work together to bargain with banks or create public options for bond underwriting and borrowing.

In situations in which our public entities have been targeted by banks, we can organize and pressure our public leaders to regain the money we lost. The city of Detroit was able to reduce its bank payments from $230 million to $85 million by exposing the invalidity of a swap.

Because swaps were often marketed to public institutions as a safe protection from variable interest rates—not as risky bets—it may be possible to pursue legal action to reclaim some of the losses. One avenue to reclaim public funds is the regulatory framework of the Municipal Securities Rulemaking Board, which mandates that municipalities be made fully aware of the risks and possible costs of entering into financial deals.

As students, we feel the impact of Wall Street every time we pay tuition. We put ourselves in thousands of dollars of debt to pay for school, but because most university borrowing is backed by student tuition, this personal debt simply begets institutional debt. All this borrowing means huge profits for the banks that finance debt, much of it coming from hidden fees and inflated payments on long-term deals with our schools.

However, as students we also have the unique opportunity to band together and make our collective voice heard. For a few years our well-being is the primary focus of a massive anchor institution, and our dollars are often the main source of its funding. We can demand better than the status quo by pressuring our schools to reclaim that money from wealthy bankers and put it back into our institutions.

If borrowing from the big banks was on fair terms and intended for long-term capital projects, it wouldn’t be a problem. Unfortunately, instead of using our nation’s wealth to pay for education, increase our human and physical capital, and build our long-run potential for growth, we are using it to increase incomes for the wealthiest bankers.

We've reached a worst-case scenario, but it doesn't have to stay that way. By holding Wall Street accountable for how it plays with tuition and tax dollars, we can bring things back around so that public investment means improving society, not improving Wall Street's balances.

Dominic Russell is a sophomore at the University of Michigan and the Roosevelt Institute | Campus Network's Policy Impact Coordinator for the Midwest. Ryan Thornton is a junior and Campus Network chapter head at George Mason University.

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How the End of GE Capital Also Kills the Core Conservative Talking Point About Dodd-Frank

Apr 10, 2015Mike Konczal

News is breaking that GE Capital will be spinning off most of its financing arm, GE Capital, over the next two years. Details are still unfolding, but, according to the initial coverage, “GE expects that by 2018 more than 90 percent of its earnings will be generated by its high-return industrial businesses, up from 58% in 2014.”

It’s good that our industrial businesses will be focusing more on innovating and services rather than financial shenanigans, but this also tells us two important things about Dodd-Frank: it confirms one of the stories about the Act and disproves the core conservative talking point about what the Act does.

Regulatory Arbitrage

A very influential theory of the financial crisis is that there were financial firms acting just like banks but without the normal safeguards that traditionally went with banks. There was no public source of liquidity or backstops through the FDIC or the Federal Reserve, a public good capable of ending self-fulfilling panics. There was no mechanism to wind down the firms and impose losses outside of the bankruptcy code. There weren’t the normal capital requirements or consumer protections that went with the traditional commercial banking sector.

Though we now call this regulatory arbitrage, at the time it was seen as innovation. GE Capital was explicitly brought up as a poster child for deregulation. You can see it in Bob Litan  and Jonathan Rauch’s 1998 American Finance for the 21st Century, which lamented the “twentieth-century model of financial policy” that, using transportation as an analogy, “set a slow speed limit, specified a few basic models for cars, separated different kinds of cars into different lanes, and demanded that no one leave home without a full tank of gas and a tune-up.” GE Capital was explicitly an example of a firm that could thrive with a regulatory regime that “focuses less on preventing mishaps and more on ensuring that an accident at any one intersection will not paralyze traffic everywhere else.”

This was very apparent in the regulatory space. The fact that GE owned a Utah savings and loan allowed it to be regulated under the leniency of the Office of Thrift Supervision (OTS), so it was able to work in the banking space without the normal rules in place. It was also able to use its high-level industrial credit rating to gamble weaker positions in the financial markets, arbitraging the private-sector regulation of the credit ratings agencies in the process.

How did that work out? First off, there was massive fraud. As Michael Hudson found in a blockbuster report, one executive declared that “fraud pays” and that “it didn’t make sense to slow the gush of loans going through the company’s pipeline, because losses due to fraud were small compared to the money the lender was making from selling huge volumes of loans.” Then there were the bailouts. The government backstopped $139 billion worth of GE Capital’s debts as it was collapsing and essentially had to manipulate the regulatory space to allow it to qualify for traditional banking protections. So much for not paralyzing traffic, and so much for the old rules not being important.

Dodd-Frank looked to normalize these regulations across both the shadow and regular banking sectors. It eliminated the OTS and declared GE Capital a systemically risky firm that has to follow higher capital requirements and prepare for bankruptcy with living wills just like we expect a bank to do, regardless of what kind of legal hijinks it is using to call itself something else. And GE Capital, faced with the prospect of having to play in the same field as everyone else, decided it should go back to trying to bring better things to life rather than making financial weapons of mass destruction. That’s pretty good news, and a process that should be encouraged and continued.

The Collapse of the Conservative Argument

But there’s one ask GE has as it spins off GE Capital, one that actually disproves the core conservative argument on Dodd-Frank. In the coverage, GE Chairman and CEO Jeff Immelt states directly, “GE will work closely with [the regulators at the Financial Stability Oversight Council] to take the actions necessary to de-designate GE Capital as a Systemically Important Financial Institution (SIFI).”

Dodd-Frank designates certain financial institutions, mostly over $50 billion in size, as systemically important. Or as the lingo goes, they get designated SIFI status. Those firms have stronger capital requirements and stronger requirements to be able to declare themselves ready for bankruptcy or FDIC resolution if they fail.

Conservatives, from the beginning, have made this the centerpiece of their story about Dodd-Frank. They argue that SIFI status is a de facto permanent bailout and claim that firms will demand to be designated as SIFIs because it means they will have a favored status. This status gives them easy crony relationships with regulators and allow them to borrow cheaply in the credit markets.

This has become doctrine on the right; I can’t think of a single movement conservative who has said the opposite. Examples of the mantra range from Peter Wallison of AEI writing “[t]he designation of SIFIs is a statement by the government that the designated firms are too big to fail” to Reason’s Nick Gillespie repeating that “everyone agrees [Dodd-Frank] has simply reinscribed too big to fail as explicit law.” (I love an “everyone agrees” without any sourcing.)

It’s also the basis of proposed policy. The Ryan budget cancels out the FDIC’s ability to regulate SIFIs, stating that Dodd-Frank “actually intensifies the problem of too-big-to-fail by giving large, interconnected financial institutions advantages that small firms will not enjoy.”

If that’s the case, GE should be desperate to maintain its SIFI status even though it is spinning off its GE Capital line. After all, being a SIFI means it gets all kinds of favored protections, access, and credit relative to other firms.

But, instead GE is desperate to lose it. This is genuine; ask any financial press reporter or analyst, and they’ll tell you that GE is very sincere when it says it doesn’t want to be designated as risky anymore, and is willing to take appropriate measures to remove the designation.

If that’s the case, what’s left of the GOP argument?

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News is breaking that GE Capital will be spinning off most of its financing arm, GE Capital, over the next two years. Details are still unfolding, but, according to the initial coverage, “GE expects that by 2018 more than 90 percent of its earnings will be generated by its high-return industrial businesses, up from 58% in 2014.”

It’s good that our industrial businesses will be focusing more on innovating and services rather than financial shenanigans, but this also tells us two important things about Dodd-Frank: it confirms one of the stories about the Act and disproves the core conservative talking point about what the Act does.

Regulatory Arbitrage

A very influential theory of the financial crisis is that there were financial firms acting just like banks but without the normal safeguards that traditionally went with banks. There was no public source of liquidity or backstops through the FDIC or the Federal Reserve, a public good capable of ending self-fulfilling panics. There was no mechanism to wind down the firms and impose losses outside of the bankruptcy code. There weren’t the normal capital requirements or consumer protections that went with the traditional commercial banking sector.

Though we now call this regulatory arbitrage, at the time it was seen as innovation. GE Capital was explicitly brought up as a poster child for deregulation. You can see it in Bob Litan  and Jonathan Rauch’s 1998 American Finance for the 21st Century, which lamented the “twentieth-century model of financial policy” that, using transportation as an analogy, “set a slow speed limit, specified a few basic models for cars, separated different kinds of cars into different lanes, and demanded that no one leave home without a full tank of gas and a tune-up.” GE Capital was explicitly an example of a firm that could thrive with a regulatory regime that “focuses less on preventing mishaps and more on ensuring that an accident at any one intersection will not paralyze traffic everywhere else.”

This was very apparent in the regulatory space. The fact that GE owned a Utah savings and loan allowed it to be regulated under the leniency of the Office of Thrift Supervision (OTS), so it was able to work in the banking space without the normal rules in place. It was also able to use its high-level industrial credit rating to gamble weaker positions in the financial markets, arbitraging the private-sector regulation of the credit ratings agencies in the process.

How did that work out? First off, there was massive fraud. As Michael Hudson found in a blockbuster report, one executive declared that “fraud pays” and that “it didn’t make sense to slow the gush of loans going through the company’s pipeline, because losses due to fraud were small compared to the money the lender was making from selling huge volumes of loans.” Then there were the bailouts. The government backstopped $139 billion worth of GE Capital’s debts as it was collapsing and essentially had to manipulate the regulatory space to allow it to qualify for traditional banking protections. So much for not paralyzing traffic, and so much for the old rules not being important.

Dodd-Frank looked to normalize these regulations across both the shadow and regular banking sectors. It eliminated the OTS and declared GE Capital a systemically risky firm that has to follow higher capital requirements and prepare for bankruptcy with living wills just like we expect a bank to do, regardless of what kind of legal hijinks it is using to call itself something else. And GE Capital, faced with the prospect of having to play in the same field as everyone else, decided it should go back to trying to bring better things to life rather than making financial weapons of mass destruction. That’s pretty good news, and a process that should be encouraged and continued.

The Collapse of the Conservative Argument

But there’s one ask GE has as it spins off GE Capital, one that actually disproves the core conservative argument on Dodd-Frank. In the coverage, GE Chairman and CEO Jeff Immelt states directly, “GE will work closely with [the regulators at the Financial Stability Oversight Council] to take the actions necessary to de-designate GE Capital as a Systemically Important Financial Institution (SIFI).”

Dodd-Frank designates certain financial institutions, mostly over $50 billion in size, as systemically important. Or as the lingo goes, they get designated SIFI status. Those firms have stronger capital requirements and stronger requirements to be able to declare themselves ready for bankruptcy or FDIC resolution if they fail.

Conservatives, from the beginning, have made this the centerpiece of their story about Dodd-Frank. They argue that SIFI status is a de facto permanent bailout and claim that firms will demand to be designated as SIFIs because it means they will have a favored status. This status gives them easy crony relationships with regulators and allow them to borrow cheaply in the credit markets.

This has become doctrine on the right; I can’t think of a single movement conservative who has said the opposite. Examples of the mantra range from Peter Wallison of AEI writing “[t]he designation of SIFIs is a statement by the government that the designated firms are too big to fail” to Reason’s Nick Gillespie repeating that “everyone agrees [Dodd-Frank] has simply reinscribed too big to fail as explicit law.” (I love an “everyone agrees” without any sourcing.)

It’s also the basis of proposed policy. The Ryan budget cancels out the FDIC’s ability to regulate SIFIs, stating that Dodd-Frank “actually intensifies the problem of too-big-to-fail by giving large, interconnected financial institutions advantages that small firms will not enjoy.”

If that’s the case, GE should be desperate to maintain its SIFI status even though it is spinning off its GE Capital line. After all, being a SIFI means it gets all kinds of favored protections, access, and credit relative to other firms.

But, instead GE is desperate to lose it. This is genuine; ask any financial press reporter or analyst, and they’ll tell you that GE is very sincere when it says it doesn’t want to be designated as risky anymore, and is willing to take appropriate measures to remove the designation.

If that’s the case, what’s left of the GOP argument?

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Is the Solution for Jamie Dimon's Next Financial Crisis a Larger US Deficit?

Apr 10, 2015Mike Konczal

In JPMorgan’s latest shareholder newsletter (p. 30-34), Jamie Dimon walks through a narrative of the next financial crisis and why we should be worried about it. But instead of worrying, I think it points to interesting details of what we’ve learned from the last crisis, what we evidently haven’t learned, and where we should go next.

Here’s Matt Levine’s summary. Dimon makes two arguments: First, the new capital requirements, especially the liquidity coverage ratio (LCR) that requires banks to fund themselves with enough liquidity to survive a 30-day crisis, will be procyclical. This means they will bind the financial sector more tightly in a crisis and prevent it from being a backstop. This is made even worse by his second argument, which is that there’s a safe asset shortage. Each individual bank is much safer than before the crisis, but using safe assets to meet the LCR means there will be fewer out there to provide stabilization when a crisis hits.

To use Dimon’s language, “there is a greatly reduced supply of Treasuries to go around – in effect, there may be a shortage of all forms of good collateral” in a crisis. Meanwhile, new capital requirements, especially the LCR, mean that in a crisis banks won’t want to lend, roll over credit, or purchase risky assets, because they would be violating the new capital rules. As such, “it will be harder for banks either as lenders or market-makers to ‘stand against the tide’” and to serve as “the ‘lender of last resort’ to their clients.”

What should we make of the fact that Dimon’s target is the LCR, an important new requirement under constant assault by the banks? Four points jump out.

The first is that the idea that we should weaken capital requirements so banks can be the lender of last resort in a financial crisis is precisely what was disproven during the 2008 panic. One reason people use the term “shadow banking” to describe this system is that it has no actual means of providing liquidity and the backstops necessary to prevent self-fulfilling panics, and that was demonstrated during the recent crisis.

Rather than financial firms heroically standing against the tide of a financial panic, they all immediately ran for shelter, forcing the Federal Reserve to stand up instead and create a de facto lender-of-last-resort facility for shadow banks out of thin air.

It’s good to hear that Dimon feels JPMorgan can still fulfill this function in the next crisis, if only we weakened Basel. But we’ve tried before to let financial firms act as the ultimate backstop to the markets while the government got out of the way, and it was a disaster. Firms like AIG wrote systemic risk insurance they could never pay; even interbank lending collapsed in the crisis.

This is precisely why we need to continue regulating the shadow banking sector and reducing reliance and risks in the wholesale short-term funding markets, and why the Federal Reserve should actually write the rules governing emergency liquidity services instead of ignoring what Congress has demanded of it. No doubt there needs to be a balance, but if anything we are counting too much on the shadow banking sector to be able to take care of itself, not too little.

As a quick, frustrating second point, it’s funny that regulators bent over backwards for the financial industry in addressing these issues with LCR, and yet the industry won’t give an inch in trying to dismantle it. That LCR is meant to adjust in a crisis and that the funds would be available for lending was emphasized when regulators weakened the rule under bank pressure, and it is explicitly stated in the final rule (“the Basel III Revised Liquidity Framework indicates that supervisory actions should not discourage or deter a banking organization from using its HQLA when necessary to meet unforeseen liquidity needs arising from financial stress that exceeds normal business fluctuations”).

If risk-weighting is too procyclical, which requires several logical leaps in Dimon’s arguments, the solution is to adjust those rules while raising the leverage ratio, not to pretend that the financial sector would be a sufficient ultimate backstop. Bank comments on tough rules like LCR are less give-and-take and more take-and-take.

But the third point is more interesting. Beyond whether or not the rules are too procyclical and unnecessarily restrictive in a crisis, there’s Dimon’s claim that there aren’t enough Treasuries to go around. If that’s the case, why don’t we simply make more Treasury debt? If the issue is a shortage of Treasuries needed to keep the financial sector well-capitalized and safe, it’s quite easy for us to make more government debt. And right now, with low interest rates and a desperate need for public investment, strikes me as an excellent time to do just that. Dimon is correct in his implicit idea that the financial markets, with enough financial engineering and private-market backstopping, can produce genuinely safe assets is a complete sham. This is a role for the government.

And for fun, a fourth point from Ben Walsh: Dimon says one of the biggest threats to the financial markets is that there isn’t enough U.S. debt. From January 2011: “Dimon Says Government Deficits, Spending Are New Global Risk.” We are risking a major rise in interest rates in the years following 2011 if we have trillion-dollar deficits, Dimon warned. How did that turn out?

Imagine how much worse shape we’d be in if we’d listened to Dimon.

So just as a friendly reminder: not only would more federal debt issued at incredibly low rates do cool things like rebuild schools, fix bridges, and give money to poor people, it would also serve as an important element of reducing the risks of the next financial crisis. This federal debt seems like a pretty useful thing to have around.

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In JPMorgan’s latest shareholder newsletter (p. 30-34), Jamie Dimon walks through a narrative of the next financial crisis and why we should be worried about it. But instead of worrying, I think it points to interesting details of what we’ve learned from the last crisis, what we evidently haven’t learned, and where we should go next.

Here’s Matt Levine’s summary. Dimon makes two arguments: First, the new capital requirements, especially the liquidity coverage ratio (LCR) that requires banks to fund themselves with enough liquidity to survive a 30-day crisis, will be procyclical. This means they will bind the financial sector more tightly in a crisis and prevent it from being a backstop. This is made even worse by his second argument, which is that there’s a safe asset shortage. Each individual bank is much safer than before the crisis, but using safe assets to meet the LCR means there will be fewer out there to provide stabilization when a crisis hits.

To use Dimon’s language, “there is a greatly reduced supply of Treasuries to go around – in effect, there may be a shortage of all forms of good collateral” in a crisis. Meanwhile, new capital requirements, especially the LCR, mean that in a crisis banks won’t want to lend, roll over credit, or purchase risky assets, because they would be violating the new capital rules. As such, “it will be harder for banks either as lenders or market-makers to ‘stand against the tide’” and to serve as “the ‘lender of last resort’ to their clients.”

What should we make of the fact that Dimon’s target is the LCR, an important new requirement under constant assault by the banks? Four points jump out.

The first is that the idea that we should weaken capital requirements so banks can be the lender of last resort in a financial crisis is precisely what was disproven during the 2008 panic. One reason people use the term “shadow banking” to describe this system is that it has no actual means of providing liquidity and the backstops necessary to prevent self-fulfilling panics, and that was demonstrated during the recent crisis.

Rather than financial firms heroically standing against the tide of a financial panic, they all immediately ran for shelter, forcing the Federal Reserve to stand up instead and create a de facto lender-of-last-resort facility for shadow banks out of thin air.

It’s good to hear that Dimon feels JPMorgan can still fulfill this function in the next crisis, if only we weakened Basel. But we’ve tried before to let financial firms act as the ultimate backstop to the markets while the government got out of the way, and it was a disaster. Firms like AIG wrote systemic risk insurance they could never pay; even interbank lending collapsed in the crisis.

This is precisely why we need to continue regulating the shadow banking sector and reducing reliance and risks in the wholesale short-term funding markets, and why the Federal Reserve should actually write the rules governing emergency liquidity services instead of ignoring what Congress has demanded of it. No doubt there needs to be a balance, but if anything we are counting too much on the shadow banking sector to be able to take care of itself, not too little.

As a quick, frustrating second point, it’s funny that regulators bent over backwards for the financial industry in addressing these issues with LCR, and yet the industry won’t give an inch in trying to dismantle it. That LCR is meant to adjust in a crisis and that the funds would be available for lending was emphasized when regulators weakened the rule under bank pressure, and it is explicitly stated in the final rule (“the Basel III Revised Liquidity Framework indicates that supervisory actions should not discourage or deter a banking organization from using its HQLA when necessary to meet unforeseen liquidity needs arising from financial stress that exceeds normal business fluctuations”).

If risk-weighting is too procyclical, which requires several logical leaps in Dimon’s arguments, the solution is to adjust those rules while raising the leverage ratio, not to pretend that the financial sector would be a sufficient ultimate backstop. Bank comments on tough rules like LCR are less give-and-take and more take-and-take.

But the third point is more interesting. Beyond whether or not the rules are too procyclical and unnecessarily restrictive in a crisis, there’s Dimon’s claim that there aren’t enough Treasuries to go around. If that’s the case, why don’t we simply make more Treasury debt? If the issue is a shortage of Treasuries needed to keep the financial sector well-capitalized and safe, it’s quite easy for us to make more government debt. And right now, with low interest rates and a desperate need for public investment, strikes me as an excellent time to do just that. Dimon is correct in his implicit idea that the financial markets, with enough financial engineering and private-market backstopping, can produce genuinely safe assets is a complete sham. This is a role for the government.

And for fun, a fourth point from Ben Walsh: Dimon says one of the biggest threats to the financial markets is that there isn’t enough U.S. debt. From January 2011: “Dimon Says Government Deficits, Spending Are New Global Risk.” We are risking a major rise in interest rates in the years following 2011 if we have trillion-dollar deficits, Dimon warned. How did that turn out?

Imagine how much worse shape we’d be in if we’d listened to Dimon.

So just as a friendly reminder: not only would more federal debt issued at incredibly low rates do cool things like rebuild schools, fix bridges, and give money to poor people, it would also serve as an important element of reducing the risks of the next financial crisis. This federal debt seems like a pretty useful thing to have around.

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Why Is Lehman Brothers Suing Georgetown from Beyond the Grave?

Apr 9, 2015Alan SmithAditya Pande

The ghost of Lehman Brothers is still haunting colleges and universities around the country, continuing to extract money from institutions even though the financial firm itself is long dead.

The ghost of Lehman Brothers is still haunting colleges and universities around the country, continuing to extract money from institutions even though the financial firm itself is long dead.

When Lehman Brothers Holdings declared bankruptcy in 2008, it was the fourth largest investment bank in the United States. The giant’s collapse was felt in all corners of the global economy, but at least that collapse was thought to be a thing of the past. Now, it turns out that Lehman Brothers lingers on as a bankruptcy group trying to collect debts from the schools it already fleeced in 2008.

In St. Louis, the haunting is public: Lehman is suing St. Louis University because it doesn’t feel the school paid a fair market value (equivalent to the termination fee at a given time) on some interest rate swap derivatives in 2008.

Let’s look at that transaction: the school paid about $25 million in early termination fees on its interest rate swaps.* SLU didn’t necessarily want to bail out of these swaps, even though they were costing the school millions; it had to terminate them because Lehman Brothers, the counterparty to the deals, was going belly up. But in a lawsuit filed in December 2014, Lehman alleges that SLU’s termination payments were short of market value and that Lehman is in fact owed another $17.5 million on these swaps. 

Let's say that again: These swaps triggered in 2008 because of the Lehman bankruptcy. The school had to pay a termination fee because the firm that owned the swaps had effectively ceased to exist. And now that firm is suing the school because it wasn’t adequately compensated for its own failure.

Here’s where the story (and related research by the Roosevelt Institute | Campus Network) gets really interesting: The ghost of Lehman isn’t just in St. Louis. Looking at the financial records of Georgetown University, there appears to be a similar story playing out in private but with even larger stakes.

Georgetown’s financials from 1998 onward are rife with big bond projects, but for now let’s focus specifically on auction rate security (ARS) bonds. These are economic devices where the interest rate paid on the bond is regularly reset through a public auction. The theory was that these auctions would allow the market to drive the interest rates to the lowest possible bidder each period; some even reset every week. These bonds were being marketed (sometimes by Lehman Brothers) as a highly liquid way to get some safe cash.

We’ve since learned that nothing could be further from the truth, as the rate markets for ARS bonds locked up in 2008 and borrowers like Georgetown were stuck paying double-digit interest rates. These bonds were more than simply investments that didn’t pan out; banks that sold the ARS bonds were also propping up the market by bidding on the rates in their own auctions, which created a false impression for buyers that the market was stable. These were bad deals made worse by illegal activity, and universities and municipalities across the country were suckered into them. When the banks eventually stopped keeping the market afloat, most such auctions failed, and the ARS market has been largely frozen since.

Although Georgetown is now almost entirely out of the ARS market and has brought down its variable-rate debt, getting rid of these increasingly expensive ARS bonds appears to have cost the schools millions in fees and even more in borrowing to pay off that debt.  Some of those bonds were underwritten by Lehman; some by other investment banks.

None of this even begins to capture the costs of the swaps, which is where this story started. The ARS bonds were cheap but had highly volatile interest rates. To mitigate these risky fluctuations, Georgetown bought interest rate swaps with Lehman Brothers. But like SLU, Georgetown did not realize it had made a deal with a potentially catastrophic downside. As the economy went into a tailspin in 2008, the Federal Reserve cut interest rates to the bone and has kept them low since; money became available for next to nothing in an attempt to keep banks from freezing up completely. This also served to drive the fair value of interest rate swaps through the roof. The worse the economy got, the more the fair market value of Georgetown’s debt hedges grew. A final insult: As the ARS rates locked up ever higher, the floating index rates that the swaps were indexed to went down, so Georgetown was losing money on every part of every deal.

And finally, finally, Lehman Brothers, which had sold swaps to so many different colleges and universities around the country, went out of business, which resulted in Georgetown having to pay Lehman more than $53 million to terminate the seven swaps it had on May 12, 2009—again, swaps that were meant to hedge against the risky ARS bonds that were also, in some cases, sold by Lehman.

Fast forward to 2012, and a lawsuit from Lehman Brothers appears on Georgetown’s financial documents. This lawsuit is only mentioned in the financial statements and has not yet gone public, so we cannot say with certainty that the story is the same as in St. Louis. However, it appears as if the disparity between the “fair market value” calculation of what the swaps were worth in 2008 and the eventual payment Georgetown made to Lehman is about the same as in the SLU case.

For those keeping score at home, this means that Georgetown was hemorrhaging money to Lehman Brothers in at least four different ways:

  1. ARS bonds marketed by Lehman cost the university $6 million in interest rates and $8.34 million in debt restructuring costs.
  2. Approximately $77.8 million in payments on the seven interest rate swaps terminated in May 2009.
  3. More than $53.4 million in swap termination fees.
  4. Though still unconfirmed, all signs point to a lawsuit from Lehman to recoup what it claims are underpayments on the “market rate” of its swaps.

The full cost is probably even higher, as these calculations do not account for the fees Georgetown paid each time it got into a bond deal, nor for other deals that Lehman did not underwrite. Still, the bill is already north of $140 million, and we’ve only been looking at publicly available records.

It certainly seems as though Georgetown was hard done by in this case, and we plan to continue our research until we can present a full tally of how much Georgetown has lost and is continuing to lose to Wall Street.

Why does this matter? After all, Georgetown is a stable institution—not like Sweet Briar or liberal arts schools, where losses in the hundreds of millions could mean the difference between solvency and closing their doors. Neither is this a public institution, where public tax dollars are being funneled into Lehman’s grave. But even a storied private institution like Georgetown is feeling the pinch of millions of dollars being extracted, and that pinch is being passed on to students.

Tuition and fees will increase 4 percent at Georgetown next year, contributing to a nearly 40 percent increase since 2006 that shows no signs of slowing down. While there are many factors in the rapid rise of education costs borne by America’s students, including the “amenities arms race” and administrative bloat, the massive debt private colleges like Georgetown have accrued and the unbelievably expensive financial engineering that has come with it deserve a lion’s share of the blame. Lehman Brothers, having already managed to scrape more than $140 million from Georgetown’s coffers, is audacious in asking for more from beyond the grave. We must be equally audacious in demanding that Wall Street pay some part of the bill it’s left students since 2008.

Is your college or nonprofit involved in an ongoing lawsuit with Lehman Brothers? Let us know!

*Interest rate swaps are a type of derivative that allows an institution to lock in a loan at a fixed rate by “swapping” its existing variable-rate loan with a bank, an idea that becomes particularly toxic when the market crashes and interest rates plummet like they did post-2008. It’s the equivalent of taking out a mortgage at 5 percent a year and then finding out the next day that mortgages are now available at 1 percent. But, unlike mortgages, swaps cannot be refinanced or even “paid off” at will. To do so, one must pay an expensive termination fee equal to the total amount the bank expects to make over the entire life of the swap. It was a lose/lose proposition for the school once its bet that interest rates would stay high didn’t work out. 

Alan Smith is the Roosevelt Institute | Campus Network's Associate Director of Networked Initiatives.

Aditya Pande is a freshman in the School of Foreign Service at Georgetown University, where he studies international economics.

Thanks to Carrie Sloan and Alexandros Taliadoros for their contributions to this post.

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What John Oliver Can Tell Us about Foreclosure Fraud, Sweat Boxes and the Profit Motive

Mar 26, 2015Mike Konczal

John Oliver dedicated his main segment on last Sunday’s episode to the epidemic of municipal fees. He walks through several stories about tickets and citations that are overpriced and end up being more expensive for poor people because of a series of burdensome fees. This was one of the conclusions of the Justice Department’s report on Ferguson, which argued that “law enforcement practices are shaped by the City’s focus on revenue rather than by public safety needs.”

Oliver had a memorable phrase to describe how this system catches people and won’t let them go: he called it a “f*** barrel,” and started a NSFW hashtag on Twitter to draw attention to it.

But I had actually heard a similar (and safe-for-work) phrase for this years ago: the “sweat box.” Law professor Ronald Mann coined it in 2006 to describe how the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) would affect consumer debt, and it applies to the criminal justice system now. The problems with this system also sound like the problems in mortgage debt servicing, which has been a focus here. It turns out that these issues are generalizable, and they illustrate some of the real dilemmas with privatization and introducing the profit-motive into the public realm.

The Sweat Box

First, the barrel/box. Credit card companies and other creditors really wanted BAPCPA to become law. But why? Mann argued that the act wouldn’t reduce risky borrowing, reduce the number of bankruptcies, or increase the recoveries these companies got in bankruptcy.

But what it would do is make it harder to start a bankruptcy, thanks to a wide variety of delaying tactics. The act did this “by raising filing fees, but also by lengthening the period between permitted filings and by imposing administrative hurdles related to credit counseling, debt relief agencies, and attorney certifications.” This kept distressed debtors in a period where they faced high fees and high interest payments, which would allow the credit card companies to collect additional revenue. Instead of trying to alter bankruptcy on the front or back ends, what it really did was give consumers fewer options and more confusion in the middle. It trapped them in a box (or over a barrel, if you will).

Mortgage Servicing

But this also sounds familiar to those watching the scandals taking place in servicer fraud as the foreclosure crisis unfolded over the past seven years. Servicers are the delegated, third-party managers of debts, particularly mortgage securitizations but also student debt. They sound disturbingly similar to the companies Oliver describes as managing municipal fees.

As Adam Levitin and Tara Twomey have argued, third-party servicing introduces three major agency problems. The first is that servicers are incentivized to pad costs, as costs are their revenues, even at the expense of everyone else. The second is that they will often pursue their own goals and objectives as the expense of other options, especially when they don’t ultimately care about the overall goals of those who hire them. And a third problem is that when problems do occur, they are often incentivized to drag them out rather than resolve them the best way possible.

Among other heart-breaking stories, Oliver walks through the story of Harriet Cleveland, who had unpaid parking tickets with Montgomery, Alabama. Montgomery, however, outsourced the management of this debt to Judicial Correction Services (JCS). JCS followed this script perfectly.

JCS had every reason to increase its fees and keep them at a burdensome rate, as it was to be paid first. It was completely indifferent to public notions of the county that hired it, such as proportional justice or the cost-benefit ratio of incarceration, such that they threw Cleveland in jail once she couldn’t handle the box anymore. And it economically benefited from keeping Cleveland in the sweat box as long as possible, rather than trying to find some way to actually resolve the tickets.

For those watching the mortgage servicing industry during the foreclosure crisis, this is a very similar story. Mortgage servicers can pyramid nuisance fees knowing that, even if the loan goes into foreclosure when the debtor can’t handle the box, they will be paid first. They are ultimately indifferent to the private notion of maximizing the value of the loan for investors, so much so that, compared to traditional banks that hold loans directly, servicers are less likely to do modifications and do them in a way that will work out. And servicers will often refuse to make good modifications that would get the mortgage current, because doing so can reduce the principal that forms the basis of their fees.

The Perils of the Profit Motive

There are three elements to draw out here. The first is that these problems are significantly worse for vulnerable populations, particularly those whose exit options are limited by background economic institutions like backruptcy or legal defense. The second is that many of our favorite buzzword policy goals, be they privatization of public services or the market-mediation of credit, involve piling on more and more of these third-party agents whose interests and powers aren’t necessarily aligned with what those who originally hired them expected. Assuming good faith for a second, privatization of these carceral services by municipalities requires a level of control of third-party agents that even the geniuses on Wall Street haven’t been able to pull off.

But we see the sweat box when it comes to purely public mechanisms too, as we see in Ferguson. So the third takeaway is that this is what happens when the profit motive is introduced in places where it normally doesn’t exist. Introducing the profit motive requires delegation and coordination, and it can often cause far more chaos than whatever efficiencies it is meant to produce. Traditional banking serviced mortgage debts as part of the everyday functions within the firm. Putting that function outside the firm, where the profit-motive was meant to increase efficiency, also created profit-driven incentives to find ways to abuse that gap in accountability.

The same dynamics come into play with the profit motive is reintroduced into the municipal level. Our government ran under the profit motive through the 1800s, and it was a major political struggle to change that. Municipal fees are very much part of the reintroduction of the profit motive into city services. As libertarian scholar and Reason Foundation co-founder Robert Poole wrote in 1980 regarding municipal court costs, “Make the users (i.e., the criminals) pay the costs, wherever possible.” As Sarah Stillman found, this is what an “offender-funded” justice system, one that aims “to shift the financial burden of probation directly onto probationers,” looks like now as for-profit carceral service providers shift their businesses to probation and parole. Catherine Rampell reports this as a total shift away from taxes and towards fees for public revenues, and the data shows it.

This is the model of the state as a business providing services, one in which those who use or abuse its functions should fund it directly. And it’s a system that can’t shake the conflicts inherent whenever the profit motive appear.

Follow or contact the Rortybomb blog:
 
  

 

John Oliver dedicated his main segment on last Sunday’s episode to the epidemic of municipal fees. He walks through several stories about tickets and citations that are overpriced and end up being more expensive for poor people because of a series of burdensome fees. This was one of the conclusions of the Justice Department’s report on Ferguson, which argued that “law enforcement practices are shaped by the City’s focus on revenue rather than by public safety needs.”

Oliver had a memorable phrase to describe how this system catches people and won’t let them go: he called it a “f*** barrel,” and started a NSFW hashtag on Twitter to draw attention to it.

But I had actually heard a similar (and safe-for-work) phrase for this years ago: the “sweat box.” Law professor Ronald Mann coined it in 2006 to describe how the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) would affect consumer debt, and it applies to the criminal justice system now. The problems with this system also sound like the problems in mortgage debt servicing, which has been a focus here. It turns out that these issues are generalizable, and they illustrate some of the real dilemmas with privatization and introducing the profit-motive into the public realm.

The Sweat Box

First, the barrel/box. Credit card companies and other creditors really wanted BAPCPA to become law. But why? Mann argued that the act wouldn’t reduce risky borrowing, reduce the number of bankruptcies, or increase the recoveries these companies got in bankruptcy.

But what it would do is make it harder to start a bankruptcy, thanks to a wide variety of delaying tactics. The act did this “by raising filing fees, but also by lengthening the period between permitted filings and by imposing administrative hurdles related to credit counseling, debt relief agencies, and attorney certifications.” This kept distressed debtors in a period where they faced high fees and high interest payments, which would allow the credit card companies to collect additional revenue. Instead of trying to alter bankruptcy on the front or back ends, what it really did was give consumers fewer options and more confusion in the middle. It trapped them in a box (or over a barrel, if you will).

Mortgage Servicing

But this also sounds familiar to those watching the scandals taking place in servicer fraud as the foreclosure crisis unfolded over the past seven years. Servicers are the delegated, third-party managers of debts, particularly mortgage securitizations but also student debt. They sound disturbingly similar to the companies Oliver describes as managing municipal fees.

As Adam Levitin and Tara Twomey have argued, third-party servicing introduces three major agency problems. The first is that servicers are incentivized to pad costs, as costs are their revenues, even at the expense of everyone else. The second is that they will often pursue their own goals and objectives as the expense of other options, especially when they don’t ultimately care about the overall goals of those who hire them. And a third problem is that when problems do occur, they are often incentivized to drag them out rather than resolve them the best way possible.

Among other heart-breaking stories, Oliver walks through the story of Harriet Cleveland, who had unpaid parking tickets with Montgomery, Alabama. Montgomery, however, outsourced the management of this debt to Judicial Correction Services (JCS). JCS followed this script perfectly.

JCS had every reason to increase its fees and keep them at a burdensome rate, as it was to be paid first. It was completely indifferent to public notions of the county that hired it, such as proportional justice or the cost-benefit ratio of incarceration, such that they threw Cleveland in jail once she couldn’t handle the box anymore. And it economically benefited from keeping Cleveland in the sweat box as long as possible, rather than trying to find some way to actually resolve the tickets.

For those watching the mortgage servicing industry during the foreclosure crisis, this is a very similar story. Mortgage servicers can pyramid nuisance fees knowing that, even if the loan goes into foreclosure when the debtor can’t handle the box, they will be paid first. They are ultimately indifferent to the private notion of maximizing the value of the loan for investors, so much so that, compared to traditional banks that hold loans directly, servicers are less likely to do modifications and do them in a way that will work out. And servicers will often refuse to make good modifications that would get the mortgage current, because doing so can reduce the principal that forms the basis of their fees.

The Perils of the Profit Motive

There are three elements to draw out here. The first is that these problems are significantly worse for vulnerable populations, particularly those whose exit options are limited by background economic institutions like backruptcy or legal defense. The second is that many of our favorite buzzword policy goals, be they privatization of public services or the market-mediation of credit, involve piling on more and more of these third-party agents whose interests and powers aren’t necessarily aligned with what those who originally hired them expected. Assuming good faith for a second, privatization of these carceral services by municipalities requires a level of control of third-party agents that even the geniuses on Wall Street haven’t been able to pull off.

But we see the sweat box when it comes to purely public mechanisms too, as we see in Ferguson. So the third takeaway is that this is what happens when the profit motive is introduced in places where it normally doesn’t exist. Introducing the profit motive requires delegation and coordination, and it can often cause far more chaos than whatever efficiencies it is meant to produce. Traditional banking serviced mortgage debts as part of the everyday functions within the firm. Putting that function outside the firm, where the profit-motive was meant to increase efficiency, also created profit-driven incentives to find ways to abuse that gap in accountability.

The same dynamics come into play with the profit motive is reintroduced into the municipal level. Our government ran under the profit motive through the 1800s, and it was a major political struggle to change that. Municipal fees are very much part of the reintroduction of the profit motive into city services. As libertarian scholar and Reason Foundation co-founder Robert Poole wrote in 1980 regarding municipal court costs, “Make the users (i.e., the criminals) pay the costs, wherever possible.” As Sarah Stillman found, this is what an “offender-funded” justice system, one that aims “to shift the financial burden of probation directly onto probationers,” looks like now as for-profit carceral service providers shift their businesses to probation and parole. Catherine Rampell reports this as a total shift away from taxes and towards fees for public revenues, and the data shows it.

This is the model of the state as a business providing services, one in which those who use or abuse its functions should fund it directly. And it’s a system that can’t shake the conflicts inherent whenever the profit motive appear.

Follow or contact the Rortybomb blog:
 
  

 

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Seven Ways Chicago Can Put Working Families Before Wall Street

Mar 24, 2015Saqib Bhatti

The ReFund America Project released a new report this morning, “Our Kind of Town: A Financial Plan that Puts Chicago’s Communities First.” The report lays out a plan for getting Chicago’s finances back on track without painful austerity measures, which exacerbate economic inequality by forcing working families to shoulder the cost.

The ReFund America Project released a new report this morning, “Our Kind of Town: A Financial Plan that Puts Chicago’s Communities First.” The report lays out a plan for getting Chicago’s finances back on track without painful austerity measures, which exacerbate economic inequality by forcing working families to shoulder the cost.

Over the last month, Moody’s Investors Service downgraded the credit ratings of the City of Chicago and Chicago Public Schools (CPS) to near junk level. Last week, Fitch Ratings followed by cutting CPS’s rating to just one notch above junk. Even though the major credit rating agencies are unreliable institutions, rife with conflicts of interest, a history of missed calls, and a reputation for using their ratings to push political agendas, these downgrades have put the issue of financial management front and center in Chicago's political debate. Questions about how best to manage the city’s money shine a spotlight on the competing interests of Chicago residents and the powerful Wall Street firms that have been profiting from the city’s financial problems.

In the developing world, the International Monetary Fund and World Bank require financially distressed governments to enact painful cuts in order to obtain financing. Moody’s and Fitch are similarly using these downgrades to push an austerity agenda in Chicago. These downgrades will benefit Wall Street firms because the city and CPS will be forced to take out more expensive products like credit enhancements and bond insurance to boost investor confidence in their bonds. Already, the city and CPS are on the hook for a combined $300 million in penalties connected to interest rate swaps as a result of these downgrades. But all of this is wholly unnecessary because none of Chicago’s governmental units are actually in any danger of defaulting on their bonds.

Moreover, this response will come at the expense of community services like education, mental health, and parks programs. Many politicians are already using the downgrades to call for austerity measures that would take a toll on Chicago’s most vulnerable residents and to justify slashing government workers’ pensions, in violation of the Illinois Constitution. State Representative Ron Sandack has even introduced a bill in the Illinois Legislature to allow municipalities to file bankruptcy in order to circumvent the state constitution’s protection of public pension funds.

The current discourse ignores the simple reality that the city is not spending too much on either public services or workers. The real problem with Chicago’s budget is that the city is hemorrhaging money on predatory financial deals with Wall Street banks and not properly taxing its wealthiest corporations and residents. Chicago needs a proactive agenda that puts the needs of communities first. In the short term, this includes measures like:

  • Recovering losses from predatory municipal finance deals. The City of Chicago, its related governmental units, and their pension funds should take all steps to recover taxpayer dollars when banks deal unfairly with them. This includes taking both legal and economic action to try get out of bad deals like interest rate swaps and recoup lost money.
  • Reducing financial fees by 20 percent across the board. The City of Chicago, its related governmental units, and their pension funds should press for negotiations demanding 20 percent reductions on all financial fees to force Wall Street firms to share in the sacrifices that Chicagoans are being forced to make every day.
  • Insourcing pension fund management. The City of Chicago and its related governmental units should bring investment management in-house for a significant portion of their pension funds’ investments, by hiring qualified staff with a proven record of effective management instead of paying Wall Street firms tens of millions of dollars each year to accomplish the same goal.
  • Ending corporate tax subsidies and tax breaks. The City of Chicago should end all corporate tax subsidies and tax breaks to major corporations, and claw back subsidies given to corporations in exchange for job creation if they did not live up to their goals of creating jobs for city residents. This includes tax subsidies from the city’s tax-increment financing (TIF) programs.

In the longer run, Chicago needs structural solutions. This includes:

  • Collective bargaining with Wall Street. The City of Chicago, its related governmental units, and their pension funds should identify financial fees that bear no reasonable relationship to the costs of providing the service and join with other cities in the region and across the country to create a new industry standard for fees and refuse to do business with any bank that does not abide by that standard.
  • Creating a public bank. The City of Chicago should establish a public bank that is owned by taxpayers and can deliver a range of services, including municipal finance, and provide capital for local economic development and affordable housing in Chicago’s neighborhoods.
  • Raising progressive revenue. The City of Chicago should work to raise progressive revenue by instituting measures like a graduated city income tax to force high earners to pay their fair share, a commuter tax on suburban residents who work in the city, and the LaSalle Street Tax on financial transactions at the Chicago Board of Trade and the Chicago Board Options Exchange. All of these likely require state approval, so the mayor would have to petition the state for authorization. California and Minnesota have both enacted progressive revenue measures in recent years that have helped solve their respective budget crises.

These steps will allow Chicago to reclaim power in its relationship with Wall Street and create a financial regime in the city that will put the interests of Chicago’s communities first.

Saqib Bhatti is a Fellow at the Roosevelt Institute and Director of the ReFund America Project.

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The Sweet Briar Dilemma: Will Predatory Lending Take Down More Colleges?

Mar 16, 2015Alan Smith

After 114 years of educating young women in rural Virginia, Sweet Briar College recently announced that the 2015 academic year would be its last. It’s closing its doors, administrators say, because its model is no longer sustainable.

After 114 years of educating young women in rural Virginia, Sweet Briar College recently announced that the 2015 academic year would be its last. It’s closing its doors, administrators say, because its model is no longer sustainable.

There are plenty of people coming out of the woodwork to explain Sweet Briar's problems. Dr. James F. Jones, the school’s president, claims that there are simply not enough people who want to attend an all-women's rural liberal arts school (though application numbers and some pundits disagree); he blames the discount that the school was giving to low-income students for the institutional budget shortfall. Billionaire investor Mark Cuban says that Sweet Briar has fallen victim to the student loan bubble and that students are unwilling to commit the money to attend, which sounds a lot like the blame-the-homeowner narrative that came out of the 2008 financial crisis.  Others are wringing their hands that small colleges in general are doomed.   

These takes are varied and complex, but they are all missing an important point: that predatory banking practices and bad financial deals played an important and nearly invisible role in precipitating the school’s budget crisis.  

A quick look at Sweet Briar’s audited financial reports (easily available in public records) reveals enough confusing and obfuscating financial-speak to last a lifetime, but a few days of digging did manage to unearth a series of troubling things.  

A single swap on a bond issued in June 2008 cost Sweet Briar more then a million dollars in payments to Wachovia before the school exited the swap in September 2011. While it is unclear exactly why they chose 2011 to pay off the remainder of the bond early, they paid a $730,119 termination fee. For a school that was sorely strapped for cash, these fines and the fees that accrued around this deal (which are hard to definitively pick out from financial documents) couldn't have come at a worse time.  

Just how big a deal are these numbers? The school has a relatively small endowment even among small liberal arts colleges: currently valued at about $88 million, with less then a quarter of that total completely unrestricted and free to spend. But in 2014, the financial year that appears to have been the final straw for Sweet Briar, total operating revenues were $34.8 million and total operating expenditures were $35.4 million, which means that the deficit the school is running is actually smaller than the cost of any of the bad deals it’s gotten itself into with banks. 

All of this puts in a very stark light the fact that the early retirement of debt (in other words, the losses the school suffered on the overall value of the bonds it had taken out because it decided to pay them back early) cost the school over $9 million in 2011 and more than $13 million in 2012. Why did the school accrue these costs? We have no way of knowing if it was bad advice from bankers, negligent trustee members covering a mistake, or a well-intentioned plan that hit at the wrong time.  

What we can say, though, is that a million dollars here and a million dollars there adds up to real money that was desperately needed as Sweet Briar fought to stay afloat.  

We know that Wall Street collects higher fees on risky and complicated deals involving variable rate debt and hedging instruments, like the ones found in Sweet Briar's last few decades of financials, than from fixed rate debt deals. We know that they add on things like credit enhancements, further driving up the costs. We know that those higher fees mean that there is a clear financial incentive to sell schools, municipalities, and pension funds on these risky deals. And we know that it works in Wall Street's favor that someone like me can spend days digging into this stuff and still not be totally sure what the exact costs of these deals are.  

What we don't know is how all these things were allowed to happen at this particular school in this particular timeframe.  

Sweet Briar appears slated to close because it is a small organization without the resources to counter the huge information imbalance that has helped precipitate the financialization crisis. It is closing because it signed some terrible deals to get what must have felt like "needed" money at the time. You can see the reasons: a $14 million bond (with swaps) in 2001 for campus improvements. A $10 million bond in 2006 to pay off other bonds that had revealed their ugly side and were costing the school too much to be allowed to fully mature. But, as has so often been the case in everything from municipal finance to personal home loans, there was a problem in the small print. Like many other colleges, what appeared to be vital and even beneficial deals turned out to be nothing of the sort. Unlike many others, Sweet Briar was already close enough to the financial brink that these ongoing debts made the difference between staying open and closing its doors.  

There are, of course, other very real pressures on Sweet Briar. Lower enrollment numbers do really hurt a school, and there are real questions about how to keep small, rural liberal arts institutions competitive in a higher education economy. None of these issues, however, compare to the fees, fines, penalties, and other losses that are all over Sweet Briar’s books. 

Is Sweet Briar the canary in the coalmine? Banks are certainly making obscene profits on the backs of the swap deals in the UC system, at the University of Michigan, and at American University — and those are the places that we’ve found in our first month of looking. While those schools are solvent enough that these swaps are not pushing them to the brink of closing, they are exacerbating budget shortfalls and passing debt on to students through increased costs. These deals are also clearly making money for many school trustees whose day jobs happen to be with the giant banks. Here I find myself agreeing with Mark Cuban, at least in part: these trends are a part of a vicious cycle of borrowing that is wholly unsustainable, and will eventually lead to a crisis.  

This is why the Roosevelt Institute | Campus Network is working to track the ways in which financial institutions are extracting wealth from our colleges and universities, and make a clear case for demanding our money back. I hope that the storied institution of Sweet Briar can find a way to keep its doors open in 2016, but even if it fails, that failure should wake us up to predatory practices at colleges and universities around the country.   

Questions? Concerns? Interested in my math? Drop me a line.

Alan Smith is the Roosevelt Institute | Campus Network's Associate Director of Networked Initiatives.

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