Four Crazy Economic Ideas You Might Hear at Tonight’s GOP Primary Debate

Aug 6, 2015Roosevelt Institute

The Republican presidential candidates will have their first televised debate of the 2016 cycle tonight. Here's what they're likely to say about the economy:

1. Cutting taxes on big corporations and top earners is the best way to grow the economy.

The Republican presidential candidates will have their first televised debate of the 2016 cycle tonight. Here's what they're likely to say about the economy:

1. Cutting taxes on big corporations and top earners is the best way to grow the economy.

All the candidates on stage tonight at the GOP primary debate will express some flavor of “trickle-down economics”—the failed idea that low taxes for the most well-off is the best policy for economic growth. Through a series of policies implemented over the past 35 years, we have already tried this tax-cutting strategy—in fact, some would say we are still in the midst of a 35-year trickle-down experiment—and as a result economic growth and business investment have slowed while inequality has risen.

To defend their position, Republican candidates will point out that America’s nominal corporate tax rate is among the highest in the world, but this is misleading. American corporations pay an effective tax rate of just 12 percent. Such a low rate could be justified if corporations were using the proceeds to fund productive investment, but the evidence does not support a connection between lower tax rates and higher investment. Today, U.S. corporations are holding more than $2 trillion sitting in offshore tax shelters, and a growing body of research shows that excess profits are used to enrich shareholders rather than improve a company’s long-term prospects for success.

Taxes on top incomes have fallen precipitously, from nearly 70 percent in 1980 to 39 percent today. While top earners have benefited from lower rates and a growing share of deductions and have captured nearly all of the economic gains of the recovery, median wages and family incomes have stagnated.

Thirty-five years of evidence is clear: the main result of cutting taxes at the top and for big corporations is more inequality, not more economic growth.

2. Supply-side policies will make the economy grow at 4 percent and solve America’s economic problems.

Jeb Bush and Chris Christie pledged to boost the economy to 4 percent growth. Historically, the United States has grown at an average annual rate of 2.9 percent, typically only growing above this trend when the economy is coming out of recession.

As we’ve seen, growth is not synonymous with broadly rising economic wellbeing. U.S. economic growth from 1979 to 2007 certainly benefited the top 1 percent of households, who saw incomes increase by 275 percent; however, compensation for the median households increased just 15 percent over this time—largely because families are working more hours, not because wages are broadly rising. 

The deck is stacked against candidates pledging 4 percent growth: The Congressional Budget Office forecasts that U.S. growth will slow to 2.1 percent by the end of the decade as the native-born labor force ages and shrinks. Not only is a 4 percent growth goal unprecedented in advanced economies like the U.S., but there is no credible way to reach 4 percent without building a more inclusive economy.

3. The United States is nearing a Greek-style debt crisis and needs more spending cuts.

The United States is not Greece. Greece’s main pitfalls were being part of a fundamentally flawed European monetary union, combined with Europe’s fundamentally flawed policy response to the financial crisis: sharp public spending cuts that plunged Greece’s economy into a tailspin, causing it to contract by 25 percent, and ballooned the debt burden, which is on track to exceed 170 percent of GDP by 2022.

Yes, the United States has debt, but at an eminently manageable level. And unlike Greece, which does not control the euro, the United States issues government bonds in a currency over which it has monetary policy control. More importantly, it matters a lot what we spend borrowed money on: war and tax cuts for corporations and the wealthy, or investments in education, infrastructure, and science that would strengthen our long-run potential for growth.

4. The Affordable Care Act and Dodd-Frank financial reform are crippling the economy and must be repealed.

A well-functioning economy needs healthy people to drive innovation and growth and a well-functioning financial system that efficiently channels savings into investment without causing systemic crises. Before the Affordable Care Act (ACA) and the Dodd-Frank Wall Street Reform and Consumer Protection Act, America lacked for both.

The ACA extended health care to 16 million people and lowered health costs for those with public and private insurance. Repealing the ACA would cast millions out from the health care system, raise health care costs across the board, kill the hallmark improvements that ended restrictions on people with pre-existing health conditions, and increase federal budget deficits by $137 billion.

Americans are still suffering the hangover of the financial crisis and housing market collapse that led to $8 trillion in lost household wealth, double-digit unemployment, and a taxpayer-subsidized bailout of the world’s largest financial institutions. Five years after Dodd-Frank, many new rules intended to prevent such a catastrophe from happening again are still yet to be implemented due to rampant opposition, such as the rule for corporations to publish CEO pay ratios.

Photo by Gage Skidmore

Share This

Introducing Our Latest Report: Defining Financialization

Jul 27, 2015Mike Konczal

We’re releasing a new report today as part of the Roosevelt Institute’s Financialization Project: Definining Financialization.

Following the well-received Disgorge The Cash, this is really the foundational paper that outlines a working definition of financialization, some of the leading concerns, worries, and research topics in each area, and a plan for future research and action. Since this is what we are building from, we’d love feedback.

Prior to this, I couldn’t find a definition of financialization broad enough to account for several different trends and accessible enough for a general, nonacademic audience. So we set out to create our own solid definition of financialization that can serve as the foundation for future research and policy. That definition includes four core elements: savings, power, wealth, and society. Put another way, financialization is the growth of the financial sector, its increased power over the real economy, the explosion in the power of wealth, and the reduction of all of society to the realm of finance.

Each of these four elements is essential, and together they tell a story about the way the economy has worked, and how it hasn’t, over the past 35 years. This enables us to understand the daunting challenges involved in reforming the financial sector, document the influence of finance over society and the economy as a whole, and clarify how finance has compounded inequality and insecurity while creating an economy that works for fewer people.

Savings: The financial sector is responsible for taking our savings and putting it toward economically productive uses. However, this sector has grown larger, more profitable, and less efficient over the past 35 years. Its goal of providing needed capital to citizens and businesses has been forgotten amid an explosion of toxic mortgage deals and the predatory pursuit of excessive fees. Beyond wasting financial resources, the sector also draws talent and energy away from more productive fields. These changes constitute the first part of our definition of financialization.

Power: Perhaps more importantly, financialization is also about the increasing control and power of finance over our productive economy and traditional businesses. The recent intellectual, ideological, and legal revolutions that have pushed CEOs to prioritize the transfer of cash to shareholders over regular, important investment in productive expansion need to be understood as part of the expansion of finance.

These historically high payouts drain resources away from productive investment. But beyond investment, there are broader worries about firms that are too dominated by the short-term interests of shareholders. These dynamics increase inequality and have a negative impact on innovation. Firms only interested in shareholder returns may be less inclined to take on the long-term, risky investment in innovation that is crucial to growth. This has spillover effects on growth and wages that can create serious long-term problems for our economy. This also makes full employment more difficult to achieve, as the delinking of corporate investment from financing has posed a serious challenge for monetary policy.

Wealth: Wealth inequality has increased dramatically in the past 35 years, and financialization includes the ways in which our laws and regulations have been overhauled to protect and expand the interests of those earning income from their wealth at the expense of everyone else. Together, these factors dramatically redistribute power and wealth upward. They also put the less wealthy at a significant disadvantage.

More important than simply creating and expanding wealth claims, policy has prioritized wealth claims over competing claims on the economy, from labor to debtors to the public. This isn’t just about increasing the power of wealth; it’s about rewriting the rules of the economy to decrease the power of everyone else.

Society: Finally, following the business professor Gerald Davis, we focus on how financialization has brought about a “portfolio society,” one in which “entire categories of social life have been securitized, turned into a kind of capital” or an investment to be managed. We now view our education and labor as “human capital,” and we imagine every person as a little corporation set to manage his or her own investments. In this view, public functions and responsibilities are mere services that should be run for profit or privatized, or both.

This way of thinking results in a radical reworking of society. Social insurance once provided across society is now deemphasized in favor of individual market solutions; for example, students take on an ever-increasing amount of debt to educate themselves. Public functions are increasingly privatized and paid for through fees, creating potential rent-seeking enterprises and further redistributing income and wealth upward. This inequality spiral saps our democracy and our ability to collectively address the nation’s greatest problems.

We have a lot of future work coming from this set of definitions, including a policy agenda and FAQ on short-termism in the near future. I hope you check this out!

Follow or contact the Rortybomb blog:
 
  

 

We’re releasing a new report today as part of the Roosevelt Institute’s Financialization Project: Definining Financialization.

Following the well-received Disgorge The Cash, this is really the foundational paper that outlines a working definition of financialization, some of the leading concerns, worries, and research topics in each area, and a plan for future research and action. Since this is what we are building from, we’d love feedback.

Prior to this, I couldn’t find a definition of financialization broad enough to account for several different trends and accessible enough for a general, nonacademic audience. So we set out to create our own solid definition of financialization that can serve as the foundation for future research and policy. That definition includes four core elements: savings, power, wealth, and society. Put another way, financialization is the growth of the financial sector, its increased power over the real economy, the explosion in the power of wealth, and the reduction of all of society to the realm of finance.

Each of these four elements is essential, and together they tell a story about the way the economy has worked, and how it hasn’t, over the past 35 years. This enables us to understand the daunting challenges involved in reforming the financial sector, document the influence of finance over society and the economy as a whole, and clarify how finance has compounded inequality and insecurity while creating an economy that works for fewer people.

Savings: The financial sector is responsible for taking our savings and putting it toward economically productive uses. However, this sector has grown larger, more profitable, and less efficient over the past 35 years. Its goal of providing needed capital to citizens and businesses has been forgotten amid an explosion of toxic mortgage deals and the predatory pursuit of excessive fees. Beyond wasting financial resources, the sector also draws talent and energy away from more productive fields. These changes constitute the first part of our definition of financialization.

Power: Perhaps more importantly, financialization is also about the increasing control and power of finance over our productive economy and traditional businesses. The recent intellectual, ideological, and legal revolutions that have pushed CEOs to prioritize the transfer of cash to shareholders over regular, important investment in productive expansion need to be understood as part of the expansion of finance.

These historically high payouts drain resources away from productive investment. But beyond investment, there are broader worries about firms that are too dominated by the short-term interests of shareholders. These dynamics increase inequality and have a negative impact on innovation. Firms only interested in shareholder returns may be less inclined to take on the long-term, risky investment in innovation that is crucial to growth. This has spillover effects on growth and wages that can create serious long-term problems for our economy. This also makes full employment more difficult to achieve, as the delinking of corporate investment from financing has posed a serious challenge for monetary policy.

Wealth: Wealth inequality has increased dramatically in the past 35 years, and financialization includes the ways in which our laws and regulations have been overhauled to protect and expand the interests of those earning income from their wealth at the expense of everyone else. Together, these factors dramatically redistribute power and wealth upward. They also put the less wealthy at a significant disadvantage.

More important than simply creating and expanding wealth claims, policy has prioritized wealth claims over competing claims on the economy, from labor to debtors to the public. This isn’t just about increasing the power of wealth; it’s about rewriting the rules of the economy to decrease the power of everyone else.

Society: Finally, following the business professor Gerald Davis, we focus on how financialization has brought about a “portfolio society,” one in which “entire categories of social life have been securitized, turned into a kind of capital” or an investment to be managed. We now view our education and labor as “human capital,” and we imagine every person as a little corporation set to manage his or her own investments. In this view, public functions and responsibilities are mere services that should be run for profit or privatized, or both.

This way of thinking results in a radical reworking of society. Social insurance once provided across society is now deemphasized in favor of individual market solutions; for example, students take on an ever-increasing amount of debt to educate themselves. Public functions are increasingly privatized and paid for through fees, creating potential rent-seeking enterprises and further redistributing income and wealth upward. This inequality spiral saps our democracy and our ability to collectively address the nation’s greatest problems.

We have a lot of future work coming from this set of definitions, including a policy agenda and FAQ on short-termism in the near future. I hope you check this out!

Follow or contact the Rortybomb blog:
 
  

 

Share This

At Vox, Dodd-Frank at 5

Jul 27, 2015Mike Konczal

In honor of Dodd-Frank's fifth birthday party last week, I wrote a 4,000 word summary of the major accomplishments of the financial reform act. It includes what is working as well as what is stalled, what needs to be amplified and what isn't yet tackled. There's a focus on the CFPB, derivatives, capital, and ending Too Big To Fail. It's aimed at both readers with little background as well as people with some familiarity, so I hope you check it out and share.

Follow or contact the Rortybomb blog:
 
  

 

In honor of Dodd-Frank's fifth birthday party last week, I wrote a 4,000 word summary of the major accomplishments of the financial reform act. It includes what is working as well as what is stalled, what needs to be amplified and what isn't yet tackled. There's a focus on the CFPB, derivatives, capital, and ending Too Big To Fail. It's aimed at both readers with little background as well as people with some familiarity, so I hope you check it out and share.

Follow or contact the Rortybomb blog:
 
  

 

Share This

Beyond Fairness: Skyrocketing CEO Pay Is Bad for Our Economy

Jul 16, 2015Susan Holmberg

Next week marks the 5th anniversary of the Dodd-Frank Wall Street Reform and Protection Act. While the law has made some solid strides toward regulating Wall Street (with the creation of the Consumer Financial Protection Bureau arguably the most potent and popular), there is still much work to be done, particularly in the realm of CEO pay reform.

Next week marks the 5th anniversary of the Dodd-Frank Wall Street Reform and Protection Act. While the law has made some solid strides toward regulating Wall Street (with the creation of the Consumer Financial Protection Bureau arguably the most potent and popular), there is still much work to be done, particularly in the realm of CEO pay reform.

From 1978 to 2014, executive compensation at American firms rose 997 percent, compared with a sluggish 10.9 percent growth in worker compensation over the same period.

While CEO pay continues its determined ascent up a seemingly limitless mountain of stock options and other performance pay, the SEC has yet to implement all of the Dodd-Frank rules designed to reform CEO pay practices. The Say-on-Pay provision, which allows shareholders an advisory vote on proposed executive compensation packages, has been in effect since 2011, and Section 954—the clawbacks provision—should soon be finalized. But the SEC continues to delay the disclosure rule on CEO–worker pay gaps, as well as a few other key provisions.

This raises a few obvious questions: Why is it so important to urge the SEC to implement these CEO pay reform rules? Does it really matter how much CEOs are paid? Isn’t this debate really just about people being jealous of, for example, former Oracle chief Larry Ellison and his Hawaiian island?

Hardly. We have to stop talking about the CEO pay issue in terms of fairness, which usually leads to accusations of envy. This conversation just doesn’t get us very far. The truth is that skyrocketing CEO pay is terrible for our economy for two reasons, as we explain in the infographic below.

To elaborate, the problems are as follows:

1. How CEOs Are Paid

The current trend in how CEOs are paid, particularly with stock options, creates a range of economic problems. Several studies show that equity-heavy pay, because it makes executives very wealthy very quickly, distorts CEOs’ incentives, inducing them to take on too much risk. Instead of bearing this risk themselves, they shift it onto the rest of society, as we saw during the financial crisis. This model also encourages executives to behave fraudulently, as in the backdating scandals of a decade ago, and lessens their motivation to invest in their businesses. In addition, according to economist William Lazonick, in order to issue stock options to top executives while avoiding the dilution of their stock, corporations often divert funds to stock buybacks rather than spending on research and development, capital investment, increased wages, or new hiring. To top it all off, these pay packages cost taxpayers billions of dollars due to the performance pay tax loophole instituted by President Clinton.

2. How Much CEOs Are Paid

In addition to its problematic structure, the sheer volume of CEO pay creates an array of economic problems. A handful of high-profile economists—Thomas Piketty, Joseph Stiglitz, and Robert Reich, to name a few—have begun to make the case that a high degree of economic inequality precipitates financial instability because it leads to, for example, a decline in consumer demand, which has tremendous spillover effects in terms of investment, job creation, and tax revenue, not to mention social instability.

The growth of executive pay is a core driver of America’s rising economic inequality. According to the Economic Policy Institute, “[e]xecutives, and workers in finance, accounted for 58 percent of the expansion of income for the top 1 percent and 67 percent of the increase in income for the top 0.1 percent from 1979 to 2005.” Another calculation by economists Ian Dew-Becker and Robert Gordon finds that the large increase in the share of the top .01 percent is mostly explained by the incomes of superstars and CEOs.

Dodd-Frank’s anniversary should remind us that we still have a long way to go to rein in ever-increasing CEO pay, including instituting key provisions like the CEO–worker pay gap. If we move the CEO pay debate beyond the rhetoric of fairness and envy to a conversation about its costs, we could galvanize the public around this issue. The evidence is clear: skyrocketing CEO pay is not just an ethical problem; it’s also simply bad economics.

Susan Holmberg is Director of Research and a Fellow at the Roosevelt Institute.

Share This

A Policy Agenda for Stronger, Fairer, and More Sustainable Growth

Jul 13, 2015Roosevelt Institute

The Roosevelt Institute today released the following statement in response to Hillary Clinton’s economic speech at the New School:

The Roosevelt Institute today released the following statement in response to Hillary Clinton’s economic speech at the New School:

Today, Hillary Clinton began outlining a comprehensive framework for tackling America’s problems of slow economic growth, low investment, and stagnant wages. Secretary Clinton’s speech reinforced an argument made by the Roosevelt Institute and supported by the economic evidence: inequality is a choice determined by the rules that structure how our economy works—the laws, regulations, and institutions that shape market behaviors and outcomes. Changes we have made to the economic rules over the past 35 years have left the U.S. with a weaker economy, higher inequality, and greater concentration of economic power. This cannot stand if the U.S. economy is to be put on track for long-term prosperity.

It is encouraging to hear Secretary Clinton focus so clearly on this central cause of America’s economic problems as she articulates a three-pronged approach to putting the U.S. economy back on track: making economic growth stronger, fairer, and oriented toward the long term. Delivering on the sweeping vision offered today will require a detailed policy agenda that addresses a number of issues ranging from family-friendly work policies to financial reform. Below, we’ve offered an outline of specific policies that we urge all presidential candidates to consider as they build their platforms.

But beyond any specific policies, an effective agenda must take a comprehensive approach to reforming the economy—an approach built on the evidence that our economy works best when it is working for everyone, not on the faith that prosperity will trickle down from a wealthy few at the very top. We cannot achieve strong, sustainable growth so long as the majority of economic gains remain concentrated in so few hands. To put it simply, stronger growth, fairer growth, and more sustainable growth are interconnected. We can’t have one without the others.

As we discussed in detail in our Rewriting the Rules of the American Economy report, there is a long list of policies that America can choose to implement in order to promote stronger, fairer, and more sustainable growth. We have summarized those policies below.

Making growth stronger

This means breaking down barriers to work: creating good jobs, sustaining good jobs, and ensuring that more Americans can obtain good jobs.

1)     Expand access to labor markets and opportunities for advancement

  • Enact paid sick and family leave so that more people can have the security to work while still caring for their children and family members.
  • Subsidize child care to benefit children and improve women's workforce participation and economic mobility.
  • Open Medicare to all to make health care more affordable for families and employers.
  • Expand public transportation to promote equal access to jobs and opportunities.
  • Reform the criminal justice system to reduce incarceration rates and penalize employers for discriminating against people with an incarceration history.
  • Enact comprehensive Immigration reform, recognizing immigrant families for their contributions to America’s economic success.
  • Protect women's access to reproductive health services so all individuals can access comprehensive, affordable, and quality care.

2)     Make public investments needed for private sector growth

  • Invest in large-scale infrastructure renovation with a 10-year campaign to make the U.S. a world leader in infrastructure manufacturing, jobs, and innovation that raises efficiency and cuts the cost of doing business in the U.S.
  • Enact universal early childhood education and a universal child benefit, ensuring that every child in America has access to pre-school starting at age 3 and that parents have the resources to invest in their children’s futures.
  • Make higher education accessible and affordable by reforming tuition financing, restoring consumer protections to student loans, and adopting universal income-based repayment.

3)     Make full employment the goal

  • Appoint members to the Federal Reserve who prioritize the Fed’s full employment mandate.
  • Restore balance to trade agreements to ensure that U.S. businesses and workers can compete with the world on a level playing field.

Making growth fairer

This means rewarding work fairly and crafting a tax code and compensation system that incentivizes investment and innovation in the real economy. 

1)    Empower workers

  • Close the pay equity gap to ensure equal pay for equal work.
  • Raise the national minimum wage and expand enforcement to ensure that work pays a living wage.
  • Strengthen the right to collective bargaining by easing legal barriers to unionization, requiring mandatory arbitration for first contracts, imposing stricter penalties on illegal anti-union activities, and amending laws to reflect the changing workplace in America.
  • Leverage government to set workplace standards by attaching strong pro-worker stipulations for private government contractors.

2)  Make taxes more progressive

  • Ensure top earners pay their fair share by raising top marginal income tax rates, replacing tax expenditures with capped credits, and taxing capital gains at least as much as labor income, with a much higher tax rate on short-term capital gains.
  • Enact revenue-positive corporate tax reform that ends the indefinite overseas deferral of corporate profits  in foreign tax havens, eliminates the incentive for offshoring by taxing corporations as unified entities on the basis of their global income, establishes a global minimum tax, and reduces corporate welfare within the tax code.

Focusing growth on the long term

This means ensuring that our financial system focuses on creating long-term value and minimizes the risks of a major financial crash.

1)     Fix the financial sector

  • Eliminate hidden subsidies to big banks that create too much risk and then hold taxpayers hostage to the need for bailouts.
  • Appoint officials to key federal agencies with a track record of enforcing regulations rather than lobbying for the industry.
  • Level the playing field between large financial institutions and community banks with increased leverage requirements and leverage surcharge.
  • Address the “shadow banking system” that eludes existing rules and regulations designed to make our economic system safe, stable, and accountable.
  • Eliminate the loopholes promoting offshore banking centers and tax havens.
  • Increase transparency throughout the financial sector so we can finally understand the risks and conflicts of interest that tip the scale of fairness and threaten to destabilize the economy.

2)    Focus corporate executives on long-term investment

  • Eliminate the CEO performance pay loophole, i.e. Section 162(m), that ties incentives to short-term stock prices rather than long-term performance; increase disclosure requirements on executive compensation and stock options; and implement the Dodd-Frank rule requiring disclosure of the CEO–median worker pay ratio.
  • Enact tax reform to combat short-termism for shareholders, first by raising tax rates on capital gains to the same level as the rates on labor income and then by raising the rate on short-term capital gains and non-productive long-term capital gains (land speculation) even higher.

3)     Rewrite the rules of trade to put all U.S. workers and businesses on a level playing field

  • Restrain the scope of the investor–state dispute settlement procedures for future agreements (and revise the myriad prior agreements) and build in safeguards so that public interest regulations cannot be undermined by private international courts.
  • Rebalance intellectual property protections to encourage innovation and lower consumer prices.
  • Make U.S. market access benefits contingent on firm audits of compliance with labor and environmental standards—a social standards export license—to give real meaning to a high-standard global economy.

Share This

The Future of Small Business Financing: Where We're Going, We Don't Need Banks

Jul 9, 2015Richard Swart

This week, the Roosevelt Institute's Next American Economy project is releasing a series of thought briefs in which experts examine how the economy will change over the next 25 years. Read the introduction here.

“We need banking, but we don’t need banks.” 

—Bill Gates, 1996

This week, the Roosevelt Institute's Next American Economy project is releasing a series of thought briefs in which experts examine how the economy will change over the next 25 years. Read the introduction here.

“We need banking, but we don’t need banks.” 

—Bill Gates, 1996

When asked to think about challenges facing small businesses as they attempt to access capital, I could not help but think of the famous quip above, which essentially predicts the end of banking as we know it. None could predict the calamitous rise and fall of the stock market, but with the near death—and eventual resurrection—of the “too big to fail” institutions, it is not hard to see the roots of this crisis running through the last 30 years.

The nature of our relationship to institutions has fundamentally changed. Whereas financial and corporate institutions held the public’s trust in the past, that trust has now shifted to networks—to shared risk, collaborative capitalism, and peer-based lending models. To future generations, the idea of one financial company providing all of our financial needs will seem foreign.

Often, crowds can better predict elections and stock prices than markets; similarly, social intelligence and signals often are more predictive of consumer behavior than past financial history. Today, credit risk can be inferred from one’s peer network, the health of a business better predicted by Yelp than by a balance sheet.

Contemporary fund-based approaches to providing access to capital often fail. Most of the funds are unprofitable, and the expectations and pressure put on early firms is antithetical to the goal of funding and supporting innovative new businesses.

In my thought brief, I speculate that the various forms of collaborative and social finance evolving since the Great Recession will build a new financial system—one that can provide a range of affordable, fast, and transparent financial services to the businesses that need them. These new models will supplant the finance industry that has systematically failed to ensure businesses have access to needed capital.

By 2040, people may read Bill Gates’s quote and wonder, what did he mean by “banks”? The future is bright. The convergence of technology, big data, and social networks has empowered a dynamic generation of fintech entrepreneurs who will create an unimaginable array of new financial products and services. In response, all but the incumbent institutions will celebrate.

Richard Swart is Crowdfunding and Alternative Finance Researcher and Scholar-in-Residence in the Institute for Business and Social Impact at the University of California, Berkeley.

Share This

Two Opposing Methods Tell Us the Too Big To Fail Subsidy Has Collapsed

Jun 11, 2015Mike Konczal

Is there a Too Big to Fail (TBTF) subsidy? If so, is it large, sustained, and institutionalized by Dodd-Frank, as many conservatives claim? Since this is always coming up in the discussion over financial reform, and especially since both those who think Dodd-Frank should be repealed and those who think it didn’t go anywhere near far enough have an incentive to argue for it, let me put out my marker.

I think the TBTF subsidy was real in the aftermath of the crisis, when it was an obvious policy to prevent a collapse of the financial system. But, contrary to the conservative argument, the subsidy has been reduced to a small amount, if it still exists at all. I also think the focus on it is a distraction. My reasoning comes less from any single study but instead from the fact that the two primary yet opposite quantitative techniques for determining such a thing both tell the same exact story—a fact that I don’t think has been caught.

This post will be written for general readers, with the financial engineering in the footnotes. A TBTF subsidy just means that the largest firms are viewed by the markets as being safer than they should be. Since they have less credit risk, they have cheaper borrowing costs, and prices of their credit risks, as measured in CDS prices, will be lower.

So how would you go about answering whether a bank has a TBTF subsidy? There are two general quantitative approaches. The first would be to compare that bank to other, non-TBTF banks, controlling for characteristics, and see whether or not it has cheaper funding. The second would be to look at the fundamentals of that bank by itself, estimate its chances of failing, and compare it to the market’s estimates. These approaches are, as a matter of methodology, the opposite of each other [1]. Yet they tell the same story. Let’s take them in turn.

First Method - Compare a Firm to Other Firms

The first approach is to simply compare TBTF firms with other firms and see if they receive lower funding. How do you do this? You get a ton of data across many different types of banks and look at the interest rates those banks get. You assume that the chances of default are random but can change based on characteristics [2]. You then do a lot of statistical regressions while trying to control for relevant variables and see if this TBTF measure provides a lower funding cost. This is what the GAO did last year.

One major problem with this technique is that you have to control for important variables. Is TBTF a matter of the size of assets, the square of the size of assets, or just a $50 billion threshold? How do you control for risks of the firm? Given that all the information comes from comparisons across firms, the way you compare a TBTF firm with a medium-sized firm matters.

This is why you can end up with the GAO estimating 42 different models: they wanted to try all their variables. But which models are really the best? The graph below summarizes their results, where they found a major subsidy in the aftermath (dots below the line reflect models showing a subsidy) of the crisis that went back to near-zero later.

Second Method - Compare a Firm to Itself

Let’s do the exact opposite with the second approach. Instead of comparing across firms, let’s create a “structural” approach that looks at the specific structures of the bank, making an estimate of how likely it is to default [3]. We then compare that estimate with actual market prices of default estimates from credit default swaps. If there’s a TBTF subsidy, that means that our estimate of the price of a credit default swap will be higher than the actual price, since the market thinks a loss is less likely.

How do we do this? We look at the bank’s balance sheet and figure out how likely it is that the value of the firm will be less than the debt. We can even phrase it like an option, which means we can hand it to the physicists to put on their Black-Scholes goggles and find a way to price it [details at 4]. The IMF recently took a crack at using the second approach and comparing the estimate to actual CDS prices.

Here’s what they found, where a positive value means the predicted price is larger than the actual price:

Opposites Strengths, Weaknesses

These two approaches aren’t just the opposite of each other; they also have opposite weaknesses. Where under the first approach it’s not really clear whether or not you are controlling for size and risk well at any moment, the structural model is able to ignore these issues by simply looking at the TBTF firm itself. But structural models need CDS prices, which are often illiquid, introducing numerous pricing problems. The first approach includes the bond market, which is quite deep. The structural model requires a lot of financial engineering modeling assumptions, where the statistical approach requires virtually no assumptions. Let's take a second and chart that out:

Note again that the two approaches are the complete opposite of each other in theory, data, and relative merits, yet they both tell the same story. There was a subsidy that was real in the aftermath of the crisis but has been coming down and is now close to zero. What should we take away from this?

First, the mission isn’t done, but we are on the right path. Higher capital requirements, liquidity requirements, living wills, restructuring, derivatives clearing, and more are paying off, removing much of the concern that the markets believe we have permanent bailouts.

You’ll hear many stories about this subsidy, but they will get all their value from the 2009–2010 period. For those on the right who argued that this would become a permanent GSE regime, this isn’t the case. The only question is whether we will go further to fully eliminate it, not whether it will be a permanent feature.

Second, we should remember that this subsidy focus was always a distraction. If Lehman Brothers had collapsed with no chaos, we’d still have millions of foreclosures, a securitization and credit market designed to rip off unsuspecting consumers, and a system of enforcement that doesn’t hold people accountable. The subsidy is only one of the major problems we have to deal with.

In addition, this subsidy equaling zero doesn’t mean that we can ignore the issue. These models can’t tell the difference between a successful and an unsuccessful resolution. This conclusion just means there would be a credit loss, but doesn’t tell if bankruptcy is an option, or if a resolution is swift, certain, well-funded, and likely to create minimal chaos for the economy. Those are our bigger concerns, which aren’t the same question at all.

Third, rolling back major parts of Dodd-Frank, particularly when it comes to TBTF policy, is a bad idea. These results are fragile; it’s easy for us to return to 2010. It would be a shame to remove the policies that are actually working well.

 

[1] It’s not exactly “reduced-form versus structural”, but if you want to learn more about these two methods (and to confirm I’m not making this up) there’s an extensive literature on it.

[2] In the jargon, defaults are thought of as exogenous, with some characteristics making a random default more likely. This will become more apparent in the second approach, when we model the default as endogenous to the structure of the firm.

[3] Full disclosure, I used to work at Moody’s KMV, a pioneer in structural models. I bleed structural modeling; it is the best.

[4] Equity is worth the firm's assets minus debt, or zero if the assets are less than debt. This is the same exact payout as a call option; the equity of the firm is simply a call option on the firms' assets, with the debt as a strike price, and as such can be modeled and priced like an option.

(For those really wedded to the myth that shareholders "own" the firm, note that in the world of Black-Scholes it's just as true to say that debtholders "own" the firm, except they sell off a derivative on their ownership to someone else.)

Follow or contact the Rortybomb blog:
 
  

 

Is there a Too Big to Fail (TBTF) subsidy? If so, is it large, sustained, and institutionalized by Dodd-Frank, as many conservatives claim? Since this is always coming up in the discussion over financial reform, and especially since both those who think Dodd-Frank should be repealed and those who think it didn’t go anywhere near far enough have an incentive to argue for it, let me put out my marker.

I think the TBTF subsidy was real in the aftermath of the crisis, when it was an obvious policy to prevent a collapse of the financial system. But, contrary to the conservative argument, the subsidy has been reduced to a small amount, if it still exists at all. I also think the focus on it is a distraction. My reasoning comes less from any single study but instead from the fact that the two primary yet opposite quantitative techniques for determining such a thing both tell the same exact story—a fact that I don’t think has been caught.

This post will be written for general readers, with the financial engineering in the footnotes. A TBTF subsidy just means that the largest firms are viewed by the markets as being safer than they should be. Since they have less credit risk, they have cheaper borrowing costs, and prices of their credit risks, as measured in CDS prices, will be lower.

So how would you go about answering whether a bank has a TBTF subsidy? There are two general quantitative approaches. The first would be to compare that bank to other, non-TBTF banks, controlling for characteristics, and see whether or not it has cheaper funding. The second would be to look at the fundamentals of that bank by itself, estimate its chances of failing, and compare it to the market’s estimates. These approaches are, as a matter of methodology, the opposite of each other [1]. Yet they tell the same story. Let’s take them in turn.

First Method - Compare a Firm to Other Firms

The first approach is to simply compare TBTF firms with other firms and see if they receive lower funding. How do you do this? You get a ton of data across many different types of banks and look at the interest rates those banks get. You assume that the chances of default are random but can change based on characteristics [2]. You then do a lot of statistical regressions while trying to control for relevant variables and see if this TBTF measure provides a lower funding cost. This is what the GAO did last year.

One major problem with this technique is that you have to control for important variables. Is TBTF a matter of the size of assets, the square of the size of assets, or just a $50 billion threshold? How do you control for risks of the firm? Given that all the information comes from comparisons across firms, the way you compare a TBTF firm with a medium-sized firm matters.

This is why you can end up with the GAO estimating 42 different models: they wanted to try all their variables. But which models are really the best? The graph below summarizes their results, where they found a major subsidy in the aftermath (dots below the line reflect models showing a subsidy) of the crisis that went back to near-zero later.

Second Method - Compare a Firm to Itself

Let’s do the exact opposite with the second approach. Instead of comparing across firms, let’s create a “structural” approach that looks at the specific structures of the bank, making an estimate of how likely it is to default [3]. We then compare that estimate with actual market prices of default estimates from credit default swaps. If there’s a TBTF subsidy, that means that our estimate of the price of a credit default swap will be higher than the actual price, since the market thinks a loss is less likely.

How do we do this? We look at the bank’s balance sheet and figure out how likely it is that the value of the firm will be less than the debt. We can even phrase it like an option, which means we can hand it to the physicists to put on their Black-Scholes goggles and find a way to price it [details at 4]. The IMF recently took a crack at using the second approach and comparing the estimate to actual CDS prices.

Here’s what they found, where a positive value means the predicted price is larger than the actual price:

Opposites Strengths, Weaknesses

These two approaches aren’t just the opposite of each other; they also have opposite weaknesses. Where under the first approach it’s not really clear whether or not you are controlling for size and risk well at any moment, the structural model is able to ignore these issues by simply looking at the TBTF firm itself. But structural models need CDS prices, which are often illiquid, introducing numerous pricing problems. The first approach includes the bond market, which is quite deep. The structural model requires a lot of financial engineering modeling assumptions, where the statistical approach requires virtually no assumptions. Let's take a second and chart that out:

Note again that the two approaches are the complete opposite of each other in theory, data, and relative merits, yet they both tell the same story. There was a subsidy that was real in the aftermath of the crisis but has been coming down and is now close to zero. What should we take away from this?

First, the mission isn’t done, but we are on the right path. Higher capital requirements, liquidity requirements, living wills, restructuring, derivatives clearing, and more are paying off, removing much of the concern that the markets believe we have permanent bailouts.

You’ll hear many stories about this subsidy, but they will get all their value from the 2009–2010 period. For those on the right who argued that this would become a permanent GSE regime, this isn’t the case. The only question is whether we will go further to fully eliminate it, not whether it will be a permanent feature.

Second, we should remember that this subsidy focus was always a distraction. If Lehman Brothers had collapsed with no chaos, we’d still have millions of foreclosures, a securitization and credit market designed to rip off unsuspecting consumers, and a system of enforcement that doesn’t hold people accountable. The subsidy is only one of the major problems we have to deal with.

In addition, this subsidy equaling zero doesn’t mean that we can ignore the issue. These models can’t tell the difference between a successful and an unsuccessful resolution. This conclusion just means there would be a credit loss, but doesn’t tell if bankruptcy is an option, or if a resolution is swift, certain, well-funded, and likely to create minimal chaos for the economy. Those are our bigger concerns, which aren’t the same question at all.

Third, rolling back major parts of Dodd-Frank, particularly when it comes to TBTF policy, is a bad idea. These results are fragile; it’s easy for us to return to 2010. It would be a shame to remove the policies that are actually working well.

 

[1] It’s not exactly “reduced-form versus structural”, but if you want to learn more about these two methods (and to confirm I’m not making this up) there’s an extensive literature on it.

[2] In the jargon, defaults are thought of as exogenous, with some characteristics making a random default more likely. This will become more apparent in the second approach, when we model the default as endogenous to the structure of the firm.

[3] Full disclosure, I used to work at Moody’s KMV, a pioneer in structural models. I bleed structural modeling; it is the best.

[4] Equity is worth the firm's assets minus debt, or zero if the assets are less than debt. This is the same exact payout as a call option; the equity of the firm is simply a call option on the firms' assets, with the debt as a strike price, and as such can be modeled and priced like an option.

(For those really wedded to the myth that shareholders "own" the firm, note that in the world of Black-Scholes it's just as true to say that debtholders "own" the firm, except they sell off a derivative on their ownership to someone else.)

Follow or contact the Rortybomb blog:
 
  

 

Share This

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:
 
  

 

Share This

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.

Share This

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.

Follow or contact the Rortybomb blog:
 
  

 

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.

Follow or contact the Rortybomb blog:
 
  

 

Share This

Pages