Jeff Madrick: Banks and Regulators Should Be Held Accountable for LIBOR

Jul 12, 2012

Roosevelt Institute Senior Fellow and Rediscovering Government director Jeff Madrick appeared on Viewpoint with Eliot Spitzer this week along with Financial Times correspondent Tracy Alloway to discuss who should bear the blame for the growing LIBOR scandal.

Roosevelt Institute Senior Fellow and Rediscovering Government director Jeff Madrick appeared on Viewpoint with Eliot Spitzer this week along with Financial Times correspondent Tracy Alloway to discuss who should bear the blame for the growing LIBOR scandal. Responding to evidence that Fed officials knew the banks were up to no good, Jeff says in the clip below that "this culture of manipulation and acceptance of manipulation I think went very deep throughout Wall Street." 

Jeff says that given these revelations, "any idea any longer that one can trust bankers or investment bankers or mortgage brokers to do the right thing and set the right rate rather than make a very easy buck should be out the window." In the online exclusive below, he adds that "the idea they let this happen should anger people on top of all the other financial crisis we've had... They should be demanding some form of justice." But he notes that banks shouldn't be the only ones sharing the blame -- there's plenty to go around for regulators "if it turns out they really fully understood it was going on, and I think they understood enough that was going on that they should be held responsible."

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New Deal Numerology: Nobody Expects the British Inquisition

Jul 12, 2012Tim Price

This week's numbers: $453 million; $800 trillion; $31 million; 20; 150

$453 million... is a chastened number. That’s how much Barclays agreed to pay U.S. and British regulators for manipulating LIBOR. If the mortgage settlement was any indication, they’ll make up that money in no time by manipulating LIBOR.

This week's numbers: $453 million; $800 trillion; $31 million; 20; 150

$453 million... is a chastened number. That’s how much Barclays agreed to pay U.S. and British regulators for manipulating LIBOR. If the mortgage settlement was any indication, they’ll make up that money in no time by manipulating LIBOR.

$800 trillion... is a mammoth number. That’s the total value of the loans and securities linked to LIBOR – over 10 times the combined GDP of every nation on Earth. With all that imaginary money, they couldn't resist creating imaginary interest rates.

$31 million... is a sacrificial number. That’s how much in bonuses ex-Barclays CEO Bob Diamond gave up when he resigned. He still settled for $2 million and the knowledge that most people would confuse him with the head of JPMorgan anyway.

20... is a scandalized number. That’s how many big banks have been named in cases related to LIBOR so far. Maybe they figured there was no real harm if they all broke the law together, like drivers deciding they'd like to try out the wrong side of the road.

150... is a complex number. That’s how many LIBORs are published daily, including 10 different currencies and 15 different time-scales. Manipulating it must have seemed like the perfect crime: one only a very bored nerd could fully comprehend. 

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Can Tighter Financial Regulation and a Smaller Financial Sector Increase Economic Growth?

Jul 9, 2012Ugo Panizza

Economists are increasingly using statistics to debunk the age-old belief that economic growth goes hand in hand with a large financial sector. 

Economists are increasingly using statistics to debunk the age-old belief that economic growth goes hand in hand with a large financial sector. 

For a long time it was simply taken for granted that a large financial sector was beneficial to economic growth. This assumption supported the long period of financial deregulation and weak enforcement that began in the 1970s. Increasingly, economists are using statistical techniques to challenge this view. In the piece below, Ugo Panizza, the international economist who works for UNCTAD, summarizes the analysis he has done to show that a large financial sector is associated with slower economic growth. Links to the detailed papers he and colleagues have done are included at the end of this post. -Jeff Madrick, Director, Rediscovering Government Initiative

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The financial system acts like the central nervous system of modern market economies. Without a functioning banking and payment system, it would be impossible to manage the complex web of economic relationships that are necessary for a modern decentralized economy. Finance facilitates the exchange of goods and services, allows diversifying and managing risk, and improves capital allocation through the production of information about investment opportunities.

However, there is also a dark side of finance. Hyman Minsky and Charles Kindleberger emphasized the relationship between finance and macroeconomic volatility and wrote extensively about financial instability and financial manias. James Tobin suggested that large financial sector can lead to a misallocation of resources and that "we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity."

A large financial sector could also capture the political process and push for policies that may bring benefits to the sector but not to society at large. This process of political capture is partly driven by campaign contributions but also by the sector's ability to promote a worldview in which what is good for finance is also good for the country. In an influential article on the lobbying power of the U.S. financial industry, former IMF chief economist Simon Johnson suggested that:

The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.

The objective of financial regulation is to strike the optimal balance between the risks and opportunities of financial deepening. After the collapse of Lehman Brothers, many observers and policymakers concluded that the process of financial deregulation that started in the 1980s went too far. It is in fact striking that, after 50 years of relative stability, deregulation was accompanied by a wave of banking, stock market, and financial crises. Calls for tighter financial regulation were eventually followed by the Dodd-Frank Wall Street Reform and Consumer Protection Act and by tighter capital standards in the Basel III international regulatory framework for banks.

Not surprisingly, the financial industry was not happy about this rather mild tightening in financial regulation. The Institute of International Finance argued that that tighter capital regulation will have a negative effect on bank profits and lead to a contraction of lending with negative consequences on future GDP growth. Along similar lines, the former chairman of the Federal Reserve, Alan Greenspan, wrote an op-ed in the Financial Times titled “Regulators must risk more, and intervene less,” stating that tighter regulation will lead to the accumulation of "idle resources that are not otherwise engaged in the production of goods and services" and are instead devoted "to fending off once-in-50 or 100-year crises," resulting in an "excess of buffers at the expense of our standards of living"

Greenspan's op-ed was followed by a debate on whether capital buffers are indeed idle resources or, as postulated by the Modigliani-Miller theorem, they have no effect on firms' valuation. To the best of my knowledge, there was no discussion on Greenspan's implicit assumption that larger financial sectors are always good for economic growth and that a reduction in total lending may have a negative effect on future standards of living.

In a new Working Paper titled “Too Much Finance?” and published by the International Monetary Fund, Jean Louis Arcand, Enrico Berkes, and I use various econometric techniques to test whether it is true that limiting the size of the financial sector has a negative effect on economic growth. We reproduce one standard result: at intermediate levels of financial depth, there is a positive relationship between the size of the financial system and economic growth. However, we also show that, at high levels of financial depth, a larger financial sector is associated with less growth. Our findings show that there can be "too much" finance. While Greenspan argued that less credit may hurt our future standard of living, our results indicate that, in countries with very large financial sectors, regulatory policies that reduce the size of the financial sector may have a positive effect on economic growth.

Countries with large financial sectors (the data are for the year 2006):

Source: Arcand, Berkes, and Panizza.

Ugo Panizza is a chief economist with UNCTAD, the United Nations agency dealing with trade, investment, and development, and is a visiting professor at the Geneva Institute.

 

References

Arcand, J.L., Berkes, E., and Panizza U. (2012) “Too Much Finance” IMF Working Paper WP/12/161 http://www.imf.org/external/pubs/ft/wp/2012/wp12161.pdf

Greenspan, A. (2011) "Regulators must risk more, and intervene less," Financial Times, July 26, 2011.

Johnson, S. (2009), "The quiet coup," The Atlantic (May 2009).

Kindleberger, C. P. (1978), Manias, Panics, and Crashes: A History of Financial Crises, Basic Books, New York.

Minsky, H. P., (1974), "The modeling of financial instability: An introduction," in Modelling and Simulation, Vol. 5, Proceedings of the Fifth Annual Pittsburgh Conference, Instruments Society of America, pp. 267—72.

Tobin, J. (1984), "On the efficiency of the financial system," Lloyds Bank Review 153, 1—15. 


This piece draws from a longer article titled “Finance and Economic Development” and published in International Development Policy (http://poldev.revues.org/?lang=en).

Wall Street image via Shutterstock.com.

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How LIBOR Impacts Financial Models and Why the Scandal Matters

Jul 9, 2012Mike Konczal

If we can't rely on the accuracy of basic measurements used to set loan prices, we can't respond effectively to brewing financial crises.

If we can't rely on the accuracy of basic measurements used to set loan prices, we can't respond effectively to brewing financial crises.

Matt Taibbi asks why nobody is freaking out about the LIBOR scandal, Robert Reich calls it the scandal of all scandals, and Dylan Matthews has a great explainer of the whole thing here. Abigail Field has more at Reality Check.

This can be confusing stuff, so I want to go through a very simple example of how this impacts the markets. Here's a basic equation for the price of a loan:

The rate of a loan consists of adding the "risk-free" rate to a risk-premium. If either the risk-free rate or risk-premium goes up, then the price of a loan goes up. If you are a particularly risky borrower, you will pay more for a loan. This is because your risk-premium, compared to other borrowers, is higher, and that is added into your loan rate. If the risk-free rate is 3 percent and your risk of not paying back a mortgage requires a 2 percent premium, then your mortgage rate is 5 percent. If your risk of not paying back unsecured debt on a credit card requires an 8 percent premium, then your interest rate on your credit card is 11 percent.

More complicated models include more types of risk-premia and other things, but this basic approach is how financial markets work. They all need a measure of what money costs independent of the risks associated with any specific loan. As a result, all the most complicated models have this "risk-free" rate at their core.

Now think of some of the scandals and controversies over recent loan pricing. Here's a great Washington Post piece by Ylan Mui on African American homeowners scarred by the subprime implosion. There are cases where people with the same risk profiles were given different interest rates. Here's a report from EPI by Algernon Austin arguing that African Americans and Latinos with the same credit risks as whites were charged a higher total interest rate for mortgages even though the risk-free rate and their risk-premium rate should have been the same. The data implies that an additional, illegitimate "+ race" was added to the equation above.

There's also debates about what is appropriate to add to the risk-premium equation. The FTC alleged that credit card companies were using charges for marriage counseling or massage parlors to increase the risk-premium, and thus the total rate. Some would argue that, from the credit risk modeling point-of-view, these are appropriate measures to hedge against divorce; others would say that it looks like a cheap excuse to jack up the total rate using the risk-premium part of the equation as an excuse.

But those issues focus on how to price risk and what the total rate should look like. Running underneath all of these loans is what the "risk-free" rate should be. And by manipulating that rate, which forms the core of any financial model of how to price a loan, you manipulate every loan. Digging through some old financial engineering textbooks, it's amusing how many mathematical cartwheels are done to try and get an edge on the movement of LIBOR. Sadly. one can't model the dynamic of making an internal phone call and asking to please manipulate the numbers.

Now let's build out from a very simple model of a financial instrument to one of the more complicated ones -- the Black-Scholes PDE for pricing options and derivatives:

There's a lot of stuff going on in this equation which you can learn about here. But there's one variable you should catch. That "r" in the equation is the risk-free rate, which is usually LIBOR. One of the things Black-Scholes does is create a framework for understanding options and derivatives as owning pieces of the underlying object along with some cash, and getting the price of a derivative by understanding what it would mean to manipulate those two items. The cash in this framework, a crucial part, has its value determined by LIBOR. Which, as many are pointing out, implicates the gigantic derivatives market in this scandal.

Implicating the derivatives market makes it clear why this matters to the market. But what about the role this scandal played in the financial crisis? This brings me to part of Karl Smith's argument for why this scandal doesn't matter much. On Up with Chris Hayes he argued that both parts of the allegations shouldn't get us too upset, and in particular that the second allegation, that Barclays systemically manipulated its LIBOR rates downward (perhaps with the approval of regulators) to make it seem like it was healthier than it was, is a good thing. Why? Because it made the financial system seem healthier than it was, which was important to prevent a collapse.

In two follow-up posts (I, II) Smith clarifies his response. Smith argues that since the central banks were facing a financial crisis of epic proportions, one that would hurt many people, banks manipulating LIBOR helped keep that crisis at bay, which is a great thing. I think Smith has a theory I'm not following in which the only problem the banks had in 2008 was insufficient monetary policy, and not the fact that these banks were sitting on hundreds of billions of dollars in toxic loans that were causing a repo market bank run combined with an opaque over-the-counter derivatives system designed to induce counterparty risk in a crisis.

But the reason it matters is because that tactic can't work forever. You can manipulate prices and juke government stress tests and otherwise lie to make people believe your bank's balance-sheet is healthier than it is, but eventually that system is going to collapse. And, crucially, if the primary objective is "delay," then when the crisis actually hits, it hits in an overwhelming way with no plausible way to fairly allocate losses or take other actions.

As a side-note, if Smith agrees with manipulating LIBOR to look healthier, then he must really support the actions the Federal Reserve Bank of New York was taking in March 2008 to juke Lehman Brother's stress tests: "The FRBNY developed two new stress scenarios: 'Bear Stearns' and 'Bear Stearns Light.' Lehman failed both tests. The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed. However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed." Thank god that prevented an out-of-nowhere collapse that totally surprised the entire market!

The "TED Spread" is the difference between LIBOR and U.S. Government debt, and many used it in 2008 to track the financial crisis in real time (here's Krugman with "My Friend TED" from the time). Pushing LIBOR down makes the TED Spread look better. This looking healthier than it should meant that there was less pressure by regulators and legislators to find ways to allow these firms to fail, and that the most obvious way of dealing with the crisis was with a mass bailout. If you really want to deal with the crisis, you should affect either end of it that the price is reflecting, by either making the banks healthier or making sure we can deal with the failure.

The possibility that the regulators were in on it further clarifies the "protect the health of the largest banks at all costs" approach, one that squeezes every last bit of blood out of our turnip housing market and creates mass unemployment through a balance-sheet recession. And even if they weren't, that means that future measures to adeqately monitor the health of the banks through disclosures and market information might also be manipulated without (or even with) serious jail time or penalties.

This, by Smith, is wrong: "To my knowledge no one takes out an adjustable rate mortgage saying, 'what I really want is for my mortgage rate to reflect the level of panic in the global financial system should there by a once in 75 year crisis.' No, what everyone thinks is that they are getting the rate set by Federal Reserve and the Bank of England."

No, if that was the case there would be no use for LIBOR, and people would just use those rates. As Nemo summarizes in a great post on LIBOR from his bond series from years ago, the people pricing any loans at LIBOR want the pricing of a systemic credit crisis in their model. As Nemo says, "It is impossible to overstate how fundamental LIBOR is to the bond market." These prices are supposed to mean something, and the ability to add that information is a crucial reason it has shown up in so many pricing models. It would be a better world if those numbers weren't being manipulated to the advantage of inside traders.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Interest rate image via Shutterstock.com.

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Today's Banks Don't Do What Banks Are Supposed to Do

Jun 27, 2012Bruce Judson

Banks in a capitalist society are meant to create wealth and decrease risk. JPMorgan and its kind do the opposite.

In his testimony before a congressional panel on the recent Swiss trading debacle, Jamie Dimon, CEO of JPMorgan Chase, said, “We’re doing what a bank is supposed to do.”

Was Dimon correct? In a capitalist economy, was Chase doing “what a bank is supposed to do"?

Banks in a capitalist society are meant to create wealth and decrease risk. JPMorgan and its kind do the opposite.

In his testimony before a congressional panel on the recent Swiss trading debacle, Jamie Dimon, CEO of JPMorgan Chase, said, “We’re doing what a bank is supposed to do.”

Was Dimon correct? In a capitalist economy, was Chase doing “what a bank is supposed to do"?

The answer is assuredly no. A bank is not supposed to do what JPMorgan Chase and its fellow too-big-to-fail compatriots do every day. They are practicing something other than actual capitalism. As this column has consistently stated, capitalism is not a vague idea. It is an economic system with well-defined principles designed to create wealth for society. These principles have powered the creation of wealth in America since the nation’s founding and empowered our country with an extraordinary resilience.

But importantly, wealth does not mean profits. Wealth is anything that can be experienced or physically used. Profits are an accounting proxy for the wealth that an entity generates. Like most proxies, the idea of profits as a measure of the wealth created for society may often be a good indicator, but as I have written previously, this proxy has failed spectacularly in the financial sector. The profits generated by today’s financial institutions bear little resemblance to the (lack of) wealth they have created for our society.

Capitalism also means there is no such thing as a “free market.” All markets require rules in order to operate fairly. The word “regulation” is really just another term for the rules that govern how participants in a market must behave. Indeed, one modern example of a free market economy may have been the period of economic chaos in Russia that followed the collapse of the Soviet Union, when the absence of rules led in part to devastating results.

Now let’s turn to the purpose of banks in a capitalist economy. Finance is an intermediary good: You cannot eat it, experience it, or physically use it. The purpose of finance is to support other activities in the economy. Banks are meant to allocate capital (funds) to the best possible use. In a capitalist economy, this means allocating money to the people or entities that will create the greatest wealth for the overall society. At the same time, risk management is supposedly a primary skill for bankers. When capital is allocated well and available to wealth creating entities, societies flourish. When capital is poorly allocated, economies can collapse.

Speaking broadly, banks allocate capital in two ways: through loans and by facilitating investments. Indeed, as we read breathless news reports on the first-day performance of IPOs, it’s easy to forget that the central purpose of an initial public offering (IPO) is to channel investment money into an enterprise that will hopefully create wealth for our entire society.

In light of today’s overly complex, overly concentrated, and overly influential financial sector, the above description may seem far too simplistic. But it's not. In Judaism, there is a well-known story of the famous Rabbi Hillel describing the essence of Judaism in a simple statement, and then saying “the rest is commentary.” The same holds true in today’s financial sector. All of finance is meant to allocate capital to the best use, the rest is commentary.

Since capitalism is a system designed to create wealth for society, gambling is antithetical not for moral reasons but because no wealth is created. Gambling is a zero-sum game. In a heads I win, tails you lose transaction, it's impossible to create wealth.

Now, let’s return to Jamie Dimon’s statement before Congress and reframe it. Was Chase “doing what banks are supposed to do”? 

First, as numerous commentators have pointed out, Chase was trading to increase its profits. This type of trading is simply gambling by another name. The outcome has no impact on the larger wealth of our society. It had nothing to do with the purpose of banks in the economy. At the same time, many of the so-called brilliant financial innovations of the recent era are, in themselves, nothing more than hidden forms of gambling.

Second, Chase was increasing rather than decreasing the risk associated with its banking functions. It has become blindingly obvious that in trading and creating complex financial instruments (also called weapons of mass destruction) our Masters of the Universe never fully understand the risks they are creating for their own institutions or our larger society.

Mr. Dimon's idea of what banks are supposed to do does not exist within the principles that makes a capitalist economy function. 

I do, however, have one question for him. I strongly suspect he would argue that the purpose of management decisions is to increase shareholder value. In 2011, the value of JPMorgan Chase’s stock price decreased by 20 percent, yet he was paid $23 million. Is this also what a bank is supposed to do?

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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Mike Konczal and Chris Hayes: How Meritocracy Produces Inequality

Jun 26, 2012Danielle Bella Ellison

In the most recent installment of “Fireside Chats,” the Roosevelt Institute’s Bloggingheads series, Fellow Mike Konczal talks with MSNBC host Chris Hayes, discussing the distortion of meritocracy and the problems of self-perpetuating elitism. As Konczal explains, the culture of “anxiety about the person who’s one step up from you” creates an environment where everyone knows everyone else is cheating, but "the rewards are so high, and conversely, the penalty for being left behind...

In the most recent installment of “Fireside Chats,” the Roosevelt Institute’s Bloggingheads series, Fellow Mike Konczal talks with MSNBC host Chris Hayes, discussing the distortion of meritocracy and the problems of self-perpetuating elitism. As Konczal explains, the culture of “anxiety about the person who’s one step up from you” creates an environment where everyone knows everyone else is cheating, but "the rewards are so high, and conversely, the penalty for being left behind... [is] so severe, then even the most unethical things become a no brainer that you’re just compelled to take part of.”

“There’s the depth of failure but also the breadth of failure,” Konczal says. In a myriad of areas, from Washington and Wall Street to the test prep industry and steroids in baseball, the system we have now is a “meritocratic competitive arms race.” This has lead to extraordinary corruption and crisis in every sphere of American life, and with it a collapse of trust in our institutions that are increasingly run by distant elites. 

To add insult to injury, this elitism is self-perpetuating. Any organization, even if it begins as completely egalitarian and democratic, will have to utilize the mechanisms of meritocracy to determine some sort of leadership. However, Hayes explains that those who end up with this power will “inevitably use that disproportionate power to subvert whatever mechanisms of accountability, turnover, mobility,” that were initially in place. Konczal laments that things have gotten so bad that failures such as WorldCom and Enron “just feel like historical footnotes now compared to Lehman Brothers." He concludes that “People need to understand that the game is rigged.”

Watch the full video below:

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Mike Konczal and Chris Hayes: How Meritocracy Produces Inequality

Jun 25, 2012

In the most recent installment of “Fireside Chats,” the Roosevelt Institute’s Bloggingheads series, Fellow Mike Konczal talks with MSNBC host Chris Hayes, discussing the distortion of meritocracy and the problems of self-perpetuating e

In the most recent installment of “Fireside Chats,” the Roosevelt Institute’s Bloggingheads series, Fellow Mike Konczal talks with MSNBC host Chris Hayes, discussing the distortion of meritocracy and the problems of self-perpetuating elitism. As Konczal explains, the culture of “anxiety about the person who’s one step up from you” creates an environment where everyone knows everyone else is cheating, but "the rewards are so high, and conversely, the penalty for being left behind... [is] so severe, then even the most unethical things become a no brainer that you’re just compelled to take part of.”

“There’s the depth of failure but also the breadth of failure,” Konczal says. In a myriad of areas, from Washington and Wall Street to the test prep industry and steroids in baseball, the system we have now is a “meritocratic competitive arms race.” This has lead to extraordinary corruption and crisis in every sphere of American life, and with it a collapse of trust in our institutions that are increasingly run by distant elites. 

To add insult to injury, this elitism is self-perpetuating. Any organization, even if it begins as completely egalitarian and democratic, will have to utilize the mechanisms of meritocracy to determine some sort of leadership. However, Hayes explains that those who end up with this power will “inevitably use that disproportionate power to subvert whatever mechanisms of accountability, turnover, mobility,” that were initially in place. Konczal laments that things have gotten so bad that failures such as WorldCom and Enron “just feel like historical footnotes now compared to Lehman Brothers." He concludes that “People need to understand that the game is rigged.”

Watch the full video below:

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Rob Johnson's Three Burning Questions the Senate Should Have Asked JP Morgan

Jun 18, 2012

The Senate may have brought JP Morgan CEO Jamie Dimon in for a hearing on the firm's $2 billion loss last week, but there was very little sizzle in his grilling. Instead of the kowtowing that took place, Roosevelt Institute Senior Fellow Rob Johnson told the Real News Network what questions he would have asked had he been in the room:

The Senate may have brought JP Morgan CEO Jamie Dimon in for a hearing on the firm's $2 billion loss last week, but there was very little sizzle in his grilling. Instead of the kowtowing that took place, Roosevelt Institute Senior Fellow Rob Johnson told the Real News Network what questions he would have asked had he been in the room:


More at The Real News

Question number one: "Why, when he claims what he’s doing is hedging other risk, he actually lost money on the hedge?" And as a follow up, to bring home the larger point: "Isn’t the Volcker rule, which separates all of this proprietary trading from other activities that society guarantees... absolutely necessary?" As Rob explains, this loss may not have been a significant portion of the bank's overall portfolio, but who's to say that the next loss isn't worse, or that a bank loses all of its capital the way Lehman did?

Question number two: "What was productive for society in the credit allocation process in that particular action?... Why does any of this activity have anything to do with making the economy function better, restoring the value or the stability in the housing market, or any of those types of real functions of financial mediation?" It can be easy to lose site of this point in all the talk of "job creators" and "doing God's work," but finance does exist for a purpose, in theory. So beyond maximizing stockholder's stock, what purpose was there for the rest of us?

And one final question: "I would be tempted to ask him why he spent so much money pulling together the entire lobbying force that used to work for Freddie Mac and Fannie Mae," Rob says. Such actions don't belie an interest in transparency, but quite the opposite: an effort to "thwart the public interest" and bury the important truths behind the bank's actions. So what are they hiding over there? If it's up to the Senate, we may never find out.

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The Senate’s Dimon Hearing Was Sadly No Pecora Commission

Jun 14, 2012David B. Woolner

Rather than digging up the truth behind Wall Street's behavior, Congress seems content to let the possibility of another crash loom.

Rather than digging up the truth behind Wall Street's behavior, Congress seems content to let the possibility of another crash loom.

Jamie Dimon’s testimony before the Senate Banking Committee yesterday has led some critics to charge that the Senators tasked with getting to the bottom of what led to JPMorgan Chase’s staggering $2-to-$5 billion dollar loss in the derivatives market have dropped the ball. In spite of Mr. Dimon’s frank admission that JPMorgan Chase, like the nation’s other big banks, was sometimes led astray by “greed, arrogance, hubris [and] lack of attention to detail,” and his additional observation that the instigation of the yet-to-be imposed Volcker Rule could have reduced the losses, Dimon faced few really tough questions. As a result, we learned little, if anything, from the hearings about the true nature of the decisions that led to the loss, or how Mr. Dimon and the CEOs of our nation’s other too big to fail banks might avoid such large losses in the future. This is particularly important if what he calls the “vague and unnecessary” Volcker Rule is ultimately watered down to the point of ineffectiveness.

Given the level of campaign contributions members of the Senate Banking Committee—on both sides of the aisle—have received from the banking industry, perhaps we should not be surprised by the coddling Mr. Dimon received in the Senate hearing room. But things were not always so cordial. Roughly 80 years ago, in the wake of the 1929 financial sector crash, the very same Senate Banking Committee, under the leadership of the committee’s indomitable chief counsel Ferdinand Pecora, excoriated members of Wall Street’s financial elite. The result was a series of revelations about the behavior—what Mr. Dimon accurately calls the “greed, arrogance [and] hubris”—of Wall Street that outraged the nation and shocked Congress into action.

In the spring of 1933, for example, under the grilling many top executives received at the hands of Pecora, who cut his teeth as a prosecutor as the Assistant Attorney General for the State of New York, the Senate Banking Committee learned that top executives at National City Bank (now Citibank) had bundled a series of bad loans to Latin American countries into securities and sold them to unsuspecting investors. The Committee also learned that these same executives had received large interest-free loans from National City’s coffers and that, as J.P. Morgan, Jr. admitted, it was fairly common practice among the members of Wall Street’s banking and financial elite to keep a list of influential “friends” who were given the opportunity to purchase stocks at drastically reduced prices. Most shocking, however, was the revelation that Mr. Morgan, who as head of the nation’s largest bank was the Warren Buffet of his day, had paid no income taxes between 1930 and 1933. Nor was he alone, for the committee soon learned that many of the nation’s other top bankers had also paid little or no income tax in the years since the 1929 crash.

These disclosures, coupled with additional revelations about excessive salaries and bonuses, outraged the public and helped inspire the incoming Roosevelt administration and Congress to push through some of the most important banking and financial reforms in American history. It is thanks in part to the work of the Senate Banking Committee, then, that the nation benefitted from such reforms as the Glass-Steagall Act, which separated commercial from investment banking and gave us the Federal Deposit Insurance Corporation; the 1933 Truth in Securities Act, which required the securities industry to provide potential investors with complete and accurate financial information about any financial product individuals or firms might wish to purchase; and the 1934 Securities and Exchange Act, which created the Securities and Exchange Commission.

Of course, the vast majority of the financial sector in 1933 and '34 vehemently opposed these reforms. But thanks to the willingness of the Senate Banking Committee to root out and expose many of the unethical practices that contributed to the collapse of the American economy, all Americans, from Wall Street to Main Street, were able to reap the benefits of a properly regulated financial sector for decades to come.

Today, most mainstream economists agree that it has been our return to the reckless and largely unregulated financial practices we saw in the 1920s, coupled with the dismantling of such key New Deal reforms as the Glass-Stegall Act, that led to the 2007-08 collapse of the world’s economy and the onset of the Great Recession. Yet the gentle treatment Mr. Dimon received at the hands of the current Senate Banking Committee pales in comparison to the penetrating line of inquiry pursued by its predecessors. This is unfortunate, for it represents yet another lost opportunity at the hands of our dysfunctional government to provide the kind of leadership required to bring about meaningful financial reform. Sadly, it seems that we would rather run the risk of another financial collapse than confront the truth about the unsustainable nature of an industry driven solely by the desire to accumulate vast quantities of wealth by whatever means necessary, no matter what the cost to the millions of Americans who still believe in an honest day’s pay for an honest day’s work.

David Woolner is a Senior Fellow and Hyde Park Resident Historian for the Roosevelt Institute. He is currently writing a book entitled Cordell Hull, Anthony Eden and the Search for Anglo-American Cooperation, 1933-1938.

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How Does Private Equity Really Make Money?

Jun 12, 2012Eileen Appelbaum

Attempts at turnarounds of failing companies are only a very small portion of private equity investments. 

Attempts at turnarounds of failing companies are only a very small portion of private equity investments. 

The distinguishing feature of private equity (PE) buyouts is that they are changes in the ownership and control of operating companies in the later stages of a company's history. The transactions are led by a private equity firm, and the firm sponsors PE funds that purchase operating companies for their portfolios. The PE firm is the general partner (GP) and makes all the decisions; pension funds and other investors are limited partners (LPs). Acquisition of an operating company entails extensive debt financing, with the burden of the debt falling on the acquired company, which is responsible for repaying it. The focus in this post is on the sources of gains to private equity investors from these leveraged buyouts.

Maybe most important, we begin by noting that private equity is not mainly engaged in buying up failing companies and trying to turn them around. The disproportionate emphasis in the media and by PE firms on efforts to turn around failing companies paints a distorted picture of what private equity does. Bill Clinton unfortunately bought into this view when he tried to explain what’s good about private equity on PBS NewsHour: "I’ve got a friend who buys failing companies, and he tries to turn them around. And he’s turned a bunch of them around, but not all of them. So sometimes he tried and failed. The effort was honorable. That’s a good thing."

The reality is that distressed investing makes up only a thin sliver of private equity investments, typically 1 to 2 percent of annual PE investments. Indeed, a study of 3,200 firms and 150,000 establishments found that establishments acquired in private equity buyouts had faster employment growth prior to takeover than comparable establishments not targeted by private equity. Private equity mainly acquires successful companies.

The sweet spot for private equity is a company doing okay in an industry whose fortunes are about to improve dramatically. This can be a source of PE returns, but it is the result of successfully timing the market.  Management fees that PE firms charge limited partners account for about two-thirds of the earnings of PE firms, but this affects the distribution of gains between GPs and LPs, and not the amount.  Net returns to investors of these fees are unclear. Top quartile PE funds are able to beat the S&P 500 index, but results for funds below the 75th percentile are ambiguous. Returns to large pension funds rarely exceed the stock market by more than the premium for holding illiquid assets. Our focus is on the nature of the private equity business model and what this tells us about the sources of aggregate gains to the GP and LP investors.

Several characteristics of the PE business model directly impact the operations of their portfolio companies:

First, private equity investments are illiquid and more highly leveraged than investments in publicly traded companies–hence, more risky. They need to yield high returns to be worth undertaking.

Second, the high debt that portfolio companies must service means they must quickly achieve an increased and predictable cash flow. Cutting costs by squeezing labor is the surest way to accomplish this.

Third, the PE model is the opposite of "patient capital." While limited partners make a long-term commitment to the PE fund, portfolio companies have only a short time to show results.

Fourth, asset stripping is typical in retail. When PE buys a department store chain, it typically splits it into a property company (prop-co) that owns the real estate and facilities that house the stores and an operating company (op-co) that runs the business. The op-co now must pay rent and no longer has a buffer to help it survive in volatile markets. PE sells the prop-co, making a profit on its initial investment regardless of whether the stores prosper.

Finally, PE will not undertake long-term investments in its portfolio companies unless capital markets are efficient and reward such investments with a higher price when the company is sold.

In most cases, top executives in operating companies face perverse incentives. They are handed a debt structure, asked to put up some of their own wealth, and promised great riches if they meet the targets set by the PE firm. If they fail to deliver quickly, they can expect to be fired. One study found that 39 percent of CEOs were replaced in the first 100 days and 69 percent in a four-year period. Like the hangman’s noose, this tends to focus managers’ minds on aggressive cost cutting.

Operational "value add" – the development and implementation of a business strategy that takes an operating company to the next level, and/or improvements in operations (supply chain management, modernization, process improvements, worker engagement) – harnesses the PE owners’ access to superior management skills and capital markets to improve performance. Buyouts of family-owned businesses and acquisitions of hospitals that lack funding to stay abreast of the latest technology are examples, as is distressed investing that rescues companies from bankruptcy. In these instances, private equity creates economic value as well as gains for PE investors. The evidence of these operating gains is thin, however, and even sympathetic academic studies are not persuasive. Greater transparency by this notoriously private industry would help establish how widespread such economic wealth-creating practices are.

The creation of economic value is one source of private equity gains. It is not the only source, however, and is often not the main source.

A second source of gains is a transfer from workers to PE investors, as employees at healthy companies that are performing well are laid off and those that remain are subject to an intensification of work. Wages and benefits may be reduced to increase predictable cash flow. Work may be shifted from union to non-union facilities. While such actions may be necessary in the case of distressed firms in need of a turnaround, the practice is applied far more widely.

Transfers from portfolio companies to PE owners are a third source of private equity gains. The portfolio company’s private equity shareholders may require it to issue junk bonds or may dip into its cash flow in order to pay them a dividend – a so-called dividend recapitalization. PE takes funds that should be used to improve portfolio company operations and create economic value. Often, this creates financial distress for the portfolio company and may even drive it into bankruptcy.

The op-co/prop-co model in retail also transfers assets from the portfolio company to its PE owners. The PE investors enrich themselves at the expense of the portfolio company, which receives little or none of the proceeds of the sale of the real estate assets. As a result, the risk of bankruptcy of the operating company increases. It may get into financial trouble and have to shutter some stores or close down entirely. As a result, the pace of job destruction in PE-owned retail establishments is far greater than in comparable non-PE owned establishments; over a five-year period, the difference cumulates to 12 percent.                 

A fourth source of gains is a transfer from taxpayers to private equity – what a state economic development officer termed "taxpayer financed capitalism." The leverage used to acquire the portfolio company alters its debt structure, increases its debt, and, because of the favorable tax treatment of debt compared to equity, reduces the company’s tax liabilities. Lower taxes raise the bottom line and increase the value of the company by 4 to 40 percent , thus increasing the returns to private equity without increasing economic value. In addition, the PE firm is more likely to be able to use tax arbitrage to legally avoid taxes. Some acquisitions are made for this purpose rather than to create value.

The final two sources of PE gains were identified in the first wave of leveraged buyouts in the 1980s. Shleifer and Summers identified breach of trust as a possible source of increased returns following an LBO. Stable enterprises depend on implicit contracts between shareholders and other stakeholders. Private equity can get a quick boost to a portfolio company’s bottom line by reneging on implicit contracts. This, however, undermines the trust necessary to the long-term sustainability of the portfolio company. Ackerlof and Romer identified the possibility of bankruptcy for profit. This occurs when a PE firm takes a portfolio company into bankruptcy and then buys it out of bankruptcy. The PE firm is still the owner, but the debts of the company have been slashed and its pension liabilities have been transferred to a government agency, the Pension Benefit Guarantee Corporation. The PE firm comes out ahead, but lenders take a haircut and workers receive reduced pensions.

The goal of public policy is to reduce incentives for rent-seeking activities by PE firms. There are several key policy changes that could have this effect: 

First, we can limit the tax deductibility of interest to remove the incentive to overleverage the acquired company. This will reduce the amount of debt placed on companies acquired by private equity. Highly leveraged companies perform poorly in volatile markets and have high rates of bankruptcy during economic downturns.

Second, we can raise the tax rate on capital gains received by individuals. There is no economic rationale for treating interest payments differently than dividends.

Third, we can tax "carried interest" – the share of the gains claimed by PE general partners, among others – as ordinary income. It is a bonus or pay for good performance and should be taxed as such.

Finally, we can require firms to make severance payments based on years of service when laying off workers. This would make layoffs a last resort rather than the first. 

Eileen Appelbaum is a Senior Economist at the Center for Economic and Policy Research.

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