Mike Konczal: Why We Should Go "All In" on the Volcker Rule

Jun 4, 2012

Last week, CNN International's Felicia Taylor invited Roosevelt Institute Fellow Mike Konczal for a night of poker, pizza, and beer. But this wasn't your typical card game -- it was actually a lesson on what the Volcker Rule is and why we need to ban proprietary trading. In the video below, watch Mike and other experts explain how letting banks gamble with their own money leaves all of us on the hook when they're dealt a bad hand.

Last week, CNN International's Felicia Taylor invited Roosevelt Institute Fellow Mike Konczal for a night of poker, pizza, and beer. But this wasn't your typical card game -- it was actually a lesson on what the Volcker Rule is and why we need to ban proprietary trading. In the video below, watch Mike and other experts explain how letting banks gamble with their own money leaves all of us on the hook when they're dealt a bad hand.

Mike says that the Volcker Rule would draw a bright line between the banks' own reserves, which it wouldn't be allowed to bet with, and its clients' money, which "can be used with adequate permission to go and gamble in the financial markets." Why the need for this distinction? Mike explains that "when you're betting with your own money, as we see with poker and as we see with any other gambling game, sometimes you lose big. You lose big very quickly out of nowhere, and those kind of immediate collapses out of nowhere cause panics, cause contagion." And once the downward spiral begins, it's not just the banks that suffer -- it's the American taxpayers who are forced to step in and cover their losses.

For more, check out Mike's explainer on the Volcker Rule at The Nation.

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Toward More Market-Oriented Financial Reforms

May 29, 2012Mike Konczal

In Joe Nocera's editorial today, "The Simplicity Solution," he calls for financial reforms to be more focused on solutions that are both simple and market-based. He draws on recent writing by Sallie Krawcheck who "lays out a handful of market-oriented ideas that would almost surely pare back the complexity risk posed by banks." Nocera goes through Krawcheck's reforms, which are focused on corporate boards and dividend policy for financial institutions.

In Joe Nocera's editorial today, "The Simplicity Solution," he calls for financial reforms to be more focused on solutions that are both simple and market-based. He draws on recent writing by Sallie Krawcheck who "lays out a handful of market-oriented ideas that would almost surely pare back the complexity risk posed by banks." Nocera goes through Krawcheck's reforms, which are focused on corporate boards and dividend policy for financial institutions.

I think people have a good sense of the arguments for simple rules in financial regulation. The clearer the lines are drawn, the less likely they are to be gamed, financially engineered-around, or ignored by regulators. As Elizabeth Warren noted in an interview with Ezra Klein, financial institutions "want layers and layers of complexity because it’s in complexity that there are loopholes. That’s where it’s possible to back up regulators who are not quite certain about the ground they stand on. And it’s a larger problem with our regulatory structure: Complexity favors those who can hire armies of lobbyists and lawyers." This is part of the big battle over the Volcker Rule.

But what about market-oriented reforms? What about reforms designed to make financial markets work better, more transparently, and in a way that prevents both cronyism and instability? The Roosevelt Institute's big financial reform program was named Make Markets Be Markets because we think that a focus on markets will be essential to the future of financial reform. There are two things worth noting: first is that the best parts of Dodd-Frank build on this insight, and secondly the first wave of battles brought by financial institutions were over smaller parts of Dodd-Frank, but parts that embraced market-based reforms.

If you look at the derivatives component of Dodd-Frank, it builds on the core essentials of New Deal financial reform for traded instruments: transparency, disclosure, clearing, capital adequacy, the regulation of intermediaries, anti-fraud and anti-manipulation authority, and private enforcement. The insight and practice is to set up the financial markets so that private entities regulate each other through transparent prices and adequate capital. Regulators need a gentler touch because they empower other parties to regulate the financial institutions in question. Clearing institutions make sure that counterparties are properly capitalized, something that was missing in the financial crisis; exchanges make sure that price information gets into the market broadly.

The same happens with the Consumer Financial Protection Bereau. The idea is to provide simple, clear rules across all firms for consumer financial products, regardless of banking charter, and let them compete against each other on price and product. Rather than racing to the bottom in terms of fees and mangled contracts, standardization of terms allows real market competition to take place. This extends across large parts of Dodd-Frank.

What's interesting is that, as I read it, the first two major battles over Dodd-Frank were precisely over these types of reforms. The first major lawsuit against Dodd-Frank, from September 2010, run by the Chamber of Commerce and the Business Roundtable, was against proxy access. Proxy access allows "[a]ny investor, or a group of investors, with at least 3 percent of a firm's shares for three years...to nominate directors." It re-balances the relationship between dispersed shareholders and boards: it allows shareholders to hold ineffectual boards accountable for everything from business practices to executive pay.

Notice that no regulator is necessary here. Shareholders are granted the power to take these actions on their own, which they'll use their their advantage as necessary. Indeed, just the threat forces boards into action, even if no proxy access is formally held. And shareholders, representing their own money and interests, are going to be more forceful as de facto regulators than a handful of actual regulators staring at and trying to regulate board composition.

The other big initial fight was over "interchange fees." On the urgent lobbying of financial firms, Congress came very close to repealing the part of Dodd-Frank that dealt with these fees in 2011, but that ultimately failed. Interchange balances the relationship between vendors and financial firms in regard to the fees charged on credit cards. It allows vendors to price discriminate between credit and debit cards, and it moves debit cards to clear at par so that people's money actually reflects their transactions. Again, no regulator is needed here. Every small business owner who feels squeezed by financial firms' fees becomes a regulator in this case. Their ability to price discriminate helps keep interchange on credit cards from spiraling out of control in a way a handful of regulators sitting in Washington DC could never pull off.

Going forward, we need Dodd-Frank implimented in the simplest, clearest regulatory way. But we also need to make sure that it makes financial markets work the way they are supposed to and allows the market itself to be the best regulator. Financial lobbyists know this, and will respond accordingly.

 

Wall Street image via Shutterstock.

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New Deal Numerology: An Equitable Arrangement

May 25, 2012Tim Price

 

This week's numbers: $607 billion; 20%; 115; $12 million; 13

$607 billion... is a transactional number. That was the aggregate value of private equity’s buyout deals at their 2007 peak. If you could sum up that period in two words, they'd be "job creation." And if you had three more words, they'd be "there was no."

 

This week's numbers: $607 billion; 20%; 115; $12 million; 13

$607 billion... is a transactional number. That was the aggregate value of private equity’s buyout deals at their 2007 peak. If you could sum up that period in two words, they'd be "job creation." And if you had three more words, they'd be "there was no."

20%... is an encouraging number. That's how much of the private equity firms' value was due to tax breaks on debt during their rise in the 1980s. If debt were like beer, our tax code would be the frat boy telling them to chug until they pass out.

115... is an acquired number. That’s how many companies Bain Capital bought out while Mitt Romney worked there. One of them was Staples, which would later base its “Easy Button” ad campaign on the real life stories of the millionaires who owned it.

$12 million... is a rewarding number. That’s how much Bain made from its buyout of GST, a steel mill that went bankrupt two years after Romney left. It must have been tough to decide whether to send his old partners condolences or congratulations.

13... is a resigned number. That’s how many years it’s been since Romney worked at Bain. It’s odd that he’d rather not focus on any of his experience since then, but his base likes firing people a lot more than giving them health care.

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What Theory is Animating Rajan's FT Mortgage-Debt Reduction Policy Recommendation?

May 23, 2012

Ok, I'm genuinely confused. There's two interesting things about this from Raghuram Rajan's Financial Times editorial, Sensible Keynesians see no easy way out, that we should unpack (my bold and numbering):

Ok, I'm genuinely confused. There's two interesting things about this from Raghuram Rajan's Financial Times editorial, Sensible Keynesians see no easy way out, that we should unpack (my bold and numbering):

The key question then is whether more government spending can make a real difference to the most severe employment problems. Here the case for a general stimulus becomes less compelling. [1] In the US, demand is weakest in communities where a boom and bust in house prices has left an overhang of household debt. Lower local demand has hit employment in industries such as retail and restaurants. A general increase in government spending may be too blunt – greater demand in New York is not going to help families eat out in Las Vegas (and hence create more restaurant jobs there). [2] Targeted household debt write-offs in Las Vegas could be a better use of stimulus dollars....
 
Targeted government spending, or reduced austerity, along the lines suggested by sensible Keynesians, might be feasible in some countries and helpful in speeding recovery. But we should examine each policy based on a country’s circumstances. We should be particularly wary of populist Keynesians, who parrot “in the long run we are dead” to justify any short-sighted government action. They do the world a disservice by suggesting there are easy ways out.
So Rajan is a sensible Keynesian who would push us towards targeted, household mortgage-debt write-offs. Meanwhile others, including presumably Paul Krugman, are a dangerous, populist variety of Keynesian who want fiscal or monetary stimulus.
 
The first numbered argument is true - places where housing prices collapsed the most are hardest hit by unemployment. But unemployment is still a nation-wide phenomenon, hitting places that didn't even have a housing bubble.  Let's chart the ratio of unemployment for April 2012 versus the unemployment for December 2007 state-by-state (source, click for larger image):

The average increase is 1.65. In New York, which Rajan singles out as being ok, unemployment has gone from 4.7 percent to 8.5 percent, which gives us an above-the-average ratio of 1.8. This is not a localized crisis.

Now Rajan is almost certainly alluding to a graph like this, which we put together a year and a half ago (sigh), of unemployment against the percentage of homes that are deeply underwater, or more than 50% underwater:

There's a lot of ways to visulize this relationship between housing bust and unemployment - Jared Bernstein had one recently. But let's examine this relationship in light of Rajan's suggestion that "Targeted household debt write-offs" could be "a better use of stimulus dollars."

There's three stories explaining this this relationship between unemployment and underwater housing. The first is a structural story. Can't turn housing construction workers into nurses, underwater homeowners can't move, etc. The mobility story turns out to be incorrect, and the "skills" story has problems we've discussed elsewhere. But notice that writing down mortgage debt doesn't make a construction worker into a nurse. So writing down mortgage debt doesn't help with this story.

There's a second story about this graph that describes a "wealth effect." People where housing values collapsed feel poorer, so they spend less. The latest Economic Report of the President argued that the "severity of losses experienced during the recession that began in December of 2007 in both national output and in labor markets makes these [wealth-effect] estimates appear too small." Also households are the net seller, but also net buyer, of housing - it's not clear, outside demographics, that housing shifts should make the macroeconomy feel poorer. But either way, writing down mortgage debt would not help with the wealth effect: if all the housing was paid in cash we'd still have the same recession under this second story.

Now there's a third story, a "balance-sheet" story of the recession. Here consumers are overleveraged and are cutting back on consumption until their balance-sheet, or their amount of debt, is repaired. In this story, reducing household mortgage debt can be a really great use of stimulus dollars. We walked through this story in this interview with Amir Sufi, who has done the leading empirical work on this. And the key, recent, theorectical work on this story, the best model of how this happens, was done by.....Paul Krugman. Specifically Eggertsson/Krugman's "Debt, Deleveraging, and the Liquidity Trap."

If the problem is household's balance-sheets, you can either make people richer or reduce their debts. Rajan thinks that taking money and writing down debt is a good idea. You could also take that money, give it to people in exchange for building useful public stuff; they can pay down debts, and then everyone has some stuff that helps the productive capabilities of the economy. You could also just give people money by not collecting taxes and mailing out checks, and they can efficiently choose whether or not to reduce debts. But under the three most common stories for the relationship between housing and debt, Rajan's policy recommendation only makes sense in the context of deleveraging, or a serious demand story, or the theory that is animating the so-called "populist" Keynesian wing.

This debate is frustratingly not new. Christina Romer was telling media in early 2009 that balance-sheet problems become worse if you let unemployment soar, even if you reduce debts. Romer: "Actually, you know, a crucial thing–when [FDR] did the bank holiday, it took the next two years to actually clean up the banks, that we actually did not get the things really cleaned up until 1935. And that a big part of that cleanup was he managed to turn around the real economy. We saw employment growing again, GDP growing again, and that inherently helps your financial system." Nothing messes up balance-sheets like mass unemployment and falling median wages.

As we've seen, writing down mortgage debt is a viciously ugly, difficult, zero-sum battle. I think it makes good sense to consider, and will have some more formal writing on it, but the idea that it is the sensible ideal while everyone else pushing fiscal or monetary stimulus is behaving irresponsibly is wrong - they both are working from the same intellectual framework.

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The Case Against Tax Breaks for Private Equity

May 23, 2012Jeff Madrick

Private equity disproportionately rewards privatization companies while others are burdened with the risks. 

Private equity disproportionately rewards privatization companies while others are burdened with the risks. 

I wanted to wait a few days before commenting on Newark Mayor Cory Booker’s spontaneous criticism of Barack Obama for picking on Mitt Romney's experience at Bain Capital. Booker doesn’t know much of anything about private equity, but many financial services donors have his ear. He took in nearly half a million dollars in campaign donations from the industry over the last nine months, and he frankly sounded like its mouthpiece.

Booker backtracked, but it would be nice if he knew something about the private equity business before he spoke publicly about it. This expectation of knowledge should also apply to widely read columnists like David Brooks, who, as usual, reflexively defended the Wall Street practice without presenting evidence. He issued a piece of public relations diatribe that no doubt soothed the right but contributed nothing to our understanding. The contention is that these buyouts turned fat American companies into lean and productive ones since the 1970s. Other pundits less well known for their conservative reflex responses have also given partial defense of private equity.

So let’s begin with one point: there is a place for private equity. In a privatization or leveraged buyout, a company is bought by an investment partnership with moneys borrowed against the company itself. The new money can be used productively even when levels of debt against the company’s assets and profits soar. A smaller company that cannot raise adequate equity can raise money by being bought by a private equity partnership. A company that is doing poorly can benefit from added capital and new management. Sometimes trimming labor costs in the process makes sense, of course. 

But the record of leveraged buyouts and private equity reflects its excesses, and most importantly, the lopsided nature of the financial incentives for doing the deals in the first place. Companies like Romney’s Bain or Steve Schwartz’s Blackstone or Kohlberg Kravis Roberts, the early industry leader when privatizations were called leverage buyouts (LBO), take advantage of a major government-provided benefit. The interest on debt is tax-deductible, and high levels of debt are the source of profits in these transactions. It is just like buying a house with a small down payment; if you can sell as the value goes up, the return on the down payment is high and the interest was deductible all along. In the meantime, the house is collateral for the loan. Similarly, partners are rarely if ever on the line for the debt; the company being privatized is. The one difference is that if the collateral value of the house falls, as it has recently, the homeowner is on the line. This is usually not so with privatizers.  

Great deal? You bet. The owners of the privatizing firm put up very little capital; it is their limited partners who put up more.  Then they borrow like mad from banks, pension funds, hedge funds and so on. If the new company can be sold or brought to market again at a higher price, they make a bundle compared to their equity down payment. The CEOs of the company, or the new executives brought in, are given huge amounts of stock. They too make a bundle. Are these incentives conducive to good business decisions?

Most likely, the investment decision is based not on how much the company can be improved, but how much can be borrowed against its assets. The second concern is the interest rate on the debt. There is no evidence that privatizers mostly buy struggling companies to resuscitate them.

Moreover, companies with high levels of debt are subject to great risk of bankruptcy. Macy’s did one of the first leveraged buyouts of its size, the CEO made out wonderfully, and soon Macy’s was in bankruptcy. It reorganized and reemerged successfully due to its retailing skills, but these were not enhanced by the LBO partners.  

Data shows the newly bought firms create fewer new jobs—or result in more lost jobs—than firms that are not subject to private takeover. But what about the much-lauded productivity gains? On balance, these target firms mostly increase productivity by selling or closing low-productivity units. Arguably, they also make their employees work harder. The fear of lay-offs can enhance productivity. There is no evidence that these firms improve productivity mostly by investing in new technologies, new managerial methods, and so on, which is often their claim.

And of course what productivity gains they have had (overall they are small) did not reinvigorate the American economy. The two main sources of productivity gains in the U.S. were high-tech companies and the retailing behemoths led by WalMart. Many retailing targets of privatizations eventually went bankrupt.

The best recent paper on private equity was written by Eileen Appelbaum of the Center for Economic and Policy Research and Rosemary Batt of Cornell University. The David Brookses of the world will cry that these researchers are of a liberal bent. But read the paper to see how carefully it is done. The exegeses of much of the right in defense of private equity are essentially outright propaganda.   

However, the basic point comes back to government and regulation. A major tax advantage gives rise to these buyouts. The privatization partnerships are lightly regulated. After-fee returns to the limited partners seem to be below average. But as for their benefits to society, privatization rewards investors by cutting short-term costs. For a long time, the stock market pushed up the stock prices of companies that kept short-term earnings growing. The influence of such corporate governance has been to keep downward pressure on wages and stoke fear in employees for three decades.

Let’s be clear; some private equity investments were healthy and some of these partnerships do a good job. But all in all, it is clear most are simply exploitations of tax law, market fashions, and their power to borrow money. There is no reason America should reward these investors with a tax break on their huge loans.   

Privatizers didn’t rebuild America. They were rarely the people who planted the garden, watered it, or designed it.  They were by and large the ones who weeded it, sometimes recklessly, throwing out the gorgeous roses in the process. Gardens do need to be weeded, but should those who do the weeding, often heedlessly, make so much more money than those who do the planting? And with the added help of government tax breaks?

In the end, Romney’s Bain made money even though its takeover target, American Pad & Paper, went out of business. Consult Appelbaum and Batt on how some of these strategies work, involving mortgaging real estate holdings and transfer pricing to reduce taxes. Privatization was mostly, if not entirely, about working the system, not building capitalism.  On balance, evidence suggests it hurt more than helped. Any way you read the evidence, it is clear the rewards for private equity firms clearly exceeded the risks. That’s not good for free markets.  

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

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Can Private Equity Firms Like Bain Do Whatever They Want With the Companies They Buy?

May 22, 2012Mike Konczal

Three critiques of the notion that private equity's actions are above public concern.

The question of Romney's tenure at private equity firm Bain Capital will stay in the headlines as the Obama team releases ads on the subject and Romney continues to run on that record. But what can we take away from this debate?

Three critiques of the notion that private equity's actions are above public concern.

The question of Romney's tenure at private equity firm Bain Capital will stay in the headlines as the Obama team releases ads on the subject and Romney continues to run on that record. But what can we take away from this debate?

Ezra Klein argues that running a leveraged buyout company ought to give one some sense of solidarity with those left behind. As LBO/private equity creates winners and losers, winners should be in favor of an expanded social safety net that helps those who lose in the layoffs get back on their feet with minimial disruptions. Since LBO overall creates more wealth, part of that wealth should be taxed for the benefit of those who need help adjusting to their new economic reality afterwards - such as providing continuous health care coverage, job training, etc.

One thing I'm noticing in these debates is an almost tautological idea that since shareholders own the firm, anything shareholders do with their firm is legitimate and outside the boundaries of public concern or critique. It was in the background of what Karl Smith was discussing on Sunday's "Up With Chris Hayes," and Josh Barro made it more explicit this morning on twitter.

A Stick

Let's imagine that I buy a stick. Under a idea of general, everyday libertarianism, since I own the stick I can do anything I want with it. I can break it in half, burn it in a fireplace, carve it into something else, turn it into woodchips, attach a kite to it, exclude people from using it, etc. I can't hit people with it, or use it to set their stuff on fire, or attach duct tape to it in order to steal their stuff - but that's a function of general prohibitions against force and fraud. Short of that, it would be weird to say that I shouldn't do whatever I want to my stick of wood - that something I do with it could be illegitimate - as long as I enjoy it.

But does a private equity firm own its portfolio businesses in the same exact way that I own my stick? Is it weird to even think, outside general prohibitions against force and fraud (which I'll treat as unproblematic as it relates to the question at hand), that their actions could be illegitimate? There are many references to increasing profits, or making firms more dynamic, or "creative destruction," but those are side effects of shareholders doing whatever they want with its portfolio. The core issue is that there could be nothing illegitimate in terms of how a private equity firm runs those businesses in the sense there's nothing illegitimate I could do with a stick I own.

Three Critiques

Starting from this baseline, the critiques as far as I read them (which will draw on two previous posts) break down along three lines:

1. Tax/regulatory loopholes. I did an interview with Josh Kosman, author of The Buyout of America, where he argued that the whole point of the enterprise is to game tax law loopholes. Private equity "saw that you could buy a company through a leveraged buyout and radically reduce its tax rate. The company then could use those savings to pay off the increase in its debt loads. For every dollar that the company paid off in debt, your equity value rises by that same dollar, as long as the value of the company remains the same."

A recent paper from the University of Chicago looking at private equity found that “a reasonable estimate of the value of lower taxes due to increased leverage for the 1980s might be 10 to 20 percent of firm value,” which is value that comes from taxpayers to private equity as a result of the tax code.

That's one thing in an industry with large and predictable cash flows. But after those low-hanging fruits were picked, as Kosman explained, "firms are taken over in very volatile industries. And they are taking on debts where they have to pay 15 times their cash flow over seven years — they are way over-levered."

This critique has power as far as it goes. But let's combine it with another issue.

2. Risk-shifting among parts of the firm. Traditional "creative destruction" is about putting rivals out of business with better products and techniques. Leveraged buyouts and private equity are about something different, something that exists within a single firm. This is often described as putting new techniques into place, firing people and divisions that are not performing, and generally making the firm more efficient.

The critique here is that, instead of making the firm more efficient, it often simply shifts the risks into different places. As Peter Róna, head of the IBJ Schroder Bank & Trust in New York, described it in 1989:

The very foundation of the LBO is the current actual distribution of hypothetical future cash flows. If the hypothesis (including the author’s net present value discounted at the relevant cost of capital) tums out to be wrong, the shareholders have the cash and everyone else is left with a carcass. “Creating shareholder value” and “unlocking billions” consists of shifting the risk of future uncertainty to others, namely, the corporation and its current creditors, customers, and employees…
 
The notion that underleveraging a corporation can cause problems is neither new nor unfounded. What is new is the assertion that shareholders shouid set the proper leverage because, motivated by maximizing the return on their investment, they will ensure efficiency of all factors of production. This hypothesis requires much more rigorous proof than Jensen’s episodic arguments… although Jensen denies it, the maximization of shareholder returns must take place, at least in part, at someone else’s expense.
Shareholders gain, but at the expense of other stakeholders in the firm. This isn't the normal winner/loser dynamic, where some suffer in the short-term to do what's best for the long-term. Here the long-term suffers to create short-term winners. Once again, this issue becomes problematic when combined with another critique.
 
3. Dividend looting. The theory behind private equity, as Róna caught above, is that it requires shareholders to be the proper and most efficient group to set the leverage ratio. But what if, instead of setting leverage for the long term to make the firm more efficient, shareholders simply use additional debt to pay themselves, regardless of the health of the firm? As Josh Kosman put it:
If you look at the dividends stuff that private equity firms do, and Bain is one of the worst offenders, if you increase the short-term earnings of a company you then use those new earnings to borrow more money. That money goes right back to the private equity firm in dividends, making it quite a quick profit. More importantly, most companies can’t handle that debt load twice. Just as they are in a position to reduce debt, they are getting hit with maximum leverage again. It’s very hard for companies to take that hit twice...
 
The initial private equity model was that you would make money by reselling your company or taking it public, not by levering it a second time...Right after this goes on for a few years, you’ve starved your firm of human and operating capital. Five years later, when the private equity leaves, the company will collapse — you can’t starve a company for that long. This is what the history of private equity shows.

This runup in dividend payouts is feature of the post 1980 financial markets more broadly, one that LBO had a hand in creating:

The blue line is profits, the solid red line is payouts. As Josh Mason noted (my bold), "In the pre-neoliberal era, up until 1980 or so, nonfinancial businesses paid out about 40 percent of their profits to shareholders. But in most of the years since 1980, they’ve paid out more than all of them...It was a common trope in accounts of the housing bubble that greedy or shortsighted homeowners were extracting equity from their houses with second mortgages or cash-out refinancings to pay for extra consumption. What nobody mentioned was that the rentier class had been doing this longer, and on a much larger scale, to the country’s productive enterprises."

Versions of these three arguments form the core of the private equity critique. Instead of simply carving a figurine or starting a BBQ, private equity uses its stick to game tax law while cashing out short-term value, leaving others in the firm worse off and the firm itself more prone to collapse and less able to produce long-term value. Do you find this critique convincing? What else is missing?

Mike Konczal is a Fellow at the Roosevelt Institute.

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J.P. Morgan Will Keep Gambling with “Other People’s Money” Without a New Glass-Steagall

May 17, 2012David B. Woolner

FDR recognized that our financial system -- and our economy -- depend on a stable banking sector.

When I speak of high finance as a harmful factor in recent years, I am speaking about a minority which includes the type of individual who speculates with other people’s money…and also the type of individual who says that popular government cannot be trusted…

FDR recognized that our financial system -- and our economy -- depend on a stable banking sector.

When I speak of high finance as a harmful factor in recent years, I am speaking about a minority which includes the type of individual who speculates with other people’s money…and also the type of individual who says that popular government cannot be trusted…

High finance of this type refused to permit Government credit to go directly to the industrialist, to the business man, to the home owner, to the farmer. They wanted it to trickle down from the top, through the intricate arrangements which they controlled and by which they were able to levy tribute on every business in the land.

…They did not want Government supervision over financial markets through which they manipulated their monopolies with other people’s money.

And in the face of their demands that Government do nothing that they called "unsound," the Government, hypnotized by its indebtedness to them, stood by and let the depression drive industry and business toward bankruptcy. –Franklin D Roosevelt, 1936

The recent news that the nation’s largest bank, JPMorgan Chase, has lost $ 2 billion in trades over the past six weeks and is likely to rack up losses in excess of $3 billion before the dust settles has led to increasing calls for the resurrection of the 1933 Glass-Steagall Act. Passed in the wake of the 1929 financial crisis that led to the onset of the Great Depression, the Glass-Steagall Act established the Federal Deposit Insurance Corporation (FDIC), which virtually ended 1930s-style bank runs, and also separated commercial from investment banking as a further guarantee of the average American’s savings.

The latter provision was put in place because of the widespread consensus among lawmakers at the time that a) it would be a mistake to allow investment bankers access to funds that were guaranteed by the government, and b) that giving investment bankers access to federally insured deposits would undermine the whole purpose of the FDIC. The FDIC was meant to provide the average American and small business person with access to stable and secure banking services for savings, mortgages, and commercial loans. In layman’s terms, this meant that financial speculators would not be able to get their hands on working Americans’ money or mortgages.

Of course, much like today, a good share of the financial sector vehemently opposed those reforms. The president of the American Bankers Association, for example, insisted that the bill’s provisions for deposit insurance were “unsound, unscientific and dangerous.” But other prominent bankers, including Winthrop Aldrich, the president of the Chase National Bank of New York and precursor to JPMorgan Chase, argued in favor of the bill, including its call for the separation of commercial and investment banking. Aldrich even went so far as to insist that the “spirit of speculation should be eradicated from the management of commercial banks, and commercial banks should not be permitted to underwrite securities.”

Flash forward to today. The likes of former Citigroup Chairmen John Reed and Richard Parsons have admitted that the repeal of Glass-Steagall contributed to the 2008 financial crisis. The current Chairman of JPMorgan Chase, Jamie Dimon himself, has admitted that Chase made “a terrible, egregious mistake” in engaging in what he termed “sloppy” and “stupid” activity in the past six weeks. Isn’t it time we recognized that common sense regulation of the banking and financial sector is vital to the overall health of our economy?

Contrary to what free market fundamentalists have been telling us again and again this campaign season, the basic banking and financial structure that was put in place in the early years of the Roosevelt administration was not put in place to strangle the free market. It was put in place to protect the free market—and it did so with great aplomb for over half a century.

If we truly wish to restore the confidence and integrity of our financial system and protect ourselves from another financial disaster, then we will need to do more than merely instigate the Volcker Rule and the other half-measures contained in the 2010 Dodd-Frank Reform Act—half-measures, which we should note, Jamie Dimon and other titans of Wall Street have so vehemently opposed.

It would be far better to heed the advice of Elizabeth Warren, Robert Reich, and a growing number of economists and members of the business community that it is time to do what the British government is essentially about to do: resurrect the Glass-Steagall Act. Doing so would not only help protect the commercial banking industry from the vicissitudes of Wall Street. It would also reduce this size of the too-big-to-fail behemoths like JPMorgan Chase, who seem quite content to gamble with what FDR called “other people’s money” in their endless pursuit of greater and greater wealth and power.

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.

 

Financial crisis image via Shutterstock.

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New Deal Numerology: Endangered Whales

May 17, 2012Tim Price

This week's numbers: $2 billion; $200 billion; 4; 3; $2.3 trillion

$2 billion... is a busted number. That’s how much JPMorgan lost in six weeks on bets made by Bruno Iksil, a.k.a. the London Whale and Voldemort. The first nickname refers to his huge trades; the second may refer to his tendency to harass orphans.

This week's numbers: $2 billion; $200 billion; 4; 3; $2.3 trillion

$2 billion... is a busted number. That’s how much JPMorgan lost in six weeks on bets made by Bruno Iksil, a.k.a. the London Whale and Voldemort. The first nickname refers to his huge trades; the second may refer to his tendency to harass orphans.

$200 billion... is a risky number. That’s the estimated value of the portfolio Iksil was betting on. Even if he doesn’t have a bright future ahead of him in the financial markets, he’ll always get comped a room when he walks into a casino.

4... is an accelerated number. That’s how many days it took JPMorgan to lose another $1 billion after the announcement. They may be resisting any attempts at financial reform, but at least they’re getting a lot more efficient about failing.

3... is a scapegoated number. That’s how many people have been asked to resign from the bank, including top female exec Ina Drew but not Iksil himself. Maybe he was nice enough to loan her his sword to fall on after she forgot to sharpen hers.

$2.3 trillion... is a cushioned number. That’s the value of JPMorgan’s assets. The bank can survive these losses, but if “Too Big to Fail” referred to physical size, this would be when paramedics had to break down its wall and airlift it out.

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Why Wall Street Needs Government Regulation to Save It From Itself

May 15, 2012Jeff Madrick

The inherent problems and contradictions of Wall Street trading make government intervention a necessity.  

The fiasco at JPMorgan Chase is most disturbing because it reflects the inherent riskiness of modern financial trading. Few articles have pinpointed this as the problem. It is the reason strong regulations and high capital requirements are necessary; you can’t outsmart these inherent contradictions.

The inherent problems and contradictions of Wall Street trading make government intervention a necessity.  

The fiasco at JPMorgan Chase is most disturbing because it reflects the inherent riskiness of modern financial trading. Few articles have pinpointed this as the problem. It is the reason strong regulations and high capital requirements are necessary; you can’t outsmart these inherent contradictions.

JPMorgan ran its trading operation out of its risk management group, which was supposed to offset risk, not take on new ones. But even if you are trying to implement a pure hedge—that is, minimize risk—there are two big issues here. One is the inefficiency of markets and the lack of adequate information. You can buy or sell a security—usually a derivative, or a leveraged security based on the ups and downs of another security—to hedge a position, such as a portfolio of bonds you think might readily fall in value. This was the Chase situation. 

However, the first problem with this is that the hedge is not necessarily properly priced, because the markets are inefficient and prices are not transparent to all. It is often too cheap. Second, the counter-party—the seller or buyer on the other side of the transaction—may not meet his or her commitment. This is what happened when AIG sold insurance (credit default swaps) to Goldman Sachs and then couldn’t pay it off without a government bailout when markets collapsed.

The next big issue is the human one. Judging from press accounts, JPMorgan wasn’t trying merely to hedge. In truth, there are no pure hedges or people wouldn’t make money at all. Nothing can eradicate risk completely. Rather, JPMorgan looked like they were taking long and short positions on balance—that is, trying to win bigger by guessing the direction of the markets, not just hedge.   

Again, there are two problems within this larger issue. First is the inalterable human temptation to make a big killing, especially when the individual bankers are being paid big bonuses to do so and suffer relatively little if they guess wrong. Call this asymmetric incentive. They may even have changed their own yardstick, or value at risk, to seem like they were taking less risk. No doubt they had some kind of argument to do so.

The second is a more subtle one. Traders usually believe that at some point securities prices will revert to their long-term values compared to each other. This was the philosophy behind the hedge fund Long-Term Capital Management (LTCM). It is very likely the traders at JPMorgan doubled down rather than try to unwind their positions, believing that markets would soon adjust to some historical averages and prove them right. The people at LTCM bought when others were selling, certain that they could hold on until markets adjusted. They could not.

These basic facts of Wall Street life are inescapable. Thus, the JPMorgan fiasco is a repeat of what happened time and again in 2007 and 2008, such as with AIG, and what happened in the 1990s with LTCM, and many others.   

Why did Jamie Dimon think he knew better? The repetition even extends to the fact that the risk manager and the trader were friends. The same was true at Citigroup before it lost a ton of money, to the surprise of its own management, as mortgage markets began to crack a few years ago.

These are fundamental, baked-in problems for Wall Street trading. Some, like today’s Wall Street Journal, will say losses are a part of capitalism and capitalists learn from their errors. The main lesson here is that they don’t learn and they can’t.

This is a job for government. Tough regulations are needed. If these firms and their employees had to absorb their own losses, perhaps there would be justification for some of these risks. That banks like JPMorgan are supported by FDIC-insured funds, that they have shareholders, and that they are so big their losses will always be guaranteed by the taxpayers, are all reasons that strong regulations are necessary. Their losses were a failure of regulation once again, reflecting the continued need for strong capital requirements, a broader Volcker rule, and transparency and margin requirements in derivatives trading. Some of that is coming. Clearly, it is not here yet and may not be here at all.

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

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JP Morgan Proves That Size Does Matter

May 15, 2012Mike Konczal

Breaking up the big banks might not be the whole solution, but it could make resolution authority more credible.

Breaking up the big banks might not be the whole solution, but it could make resolution authority more credible.

Before we start talking about the advantages and disadvantages of introducing size caps and restricting business lines through a new Glass-Steagall, it is important to understand how very big the five biggest banks are. If you need a sense of how big JP Morgan is and why it is hard for it to "hedge" without moving the market, the graph below gives you a sense. This is a graph I put together during Dodd-Frank based on data that was floating around at the time:

When bills restricting size of a large financial institution have been introduced they usually put size in the context of deposit liabilities (what we provide a backstop for and what reflects consumer savings, expressed as a percent of all deposits) and non-deposit liabilities (what reflects a blunt measure of size and potential for shadow banking runs, expressed as a percentage of GDP). The SAFE Banking Act, which has been reintroduced, mostly impacts the six firms listed above. The original SAFE Banking Act had a cap of 3 percent of GDP for non-deposit liabilities for financial firms (2 percent for actual banks) -- a space that ignores over 8,000 banks to just focus on the biggest six.

Yesterday Elizabeth Warren sent out an email with PCCC calling for a new Glass-Steagall. Let's back up: what kind of regulation do we have in the financial sector? First, there's the background regulation that structures and forms the financial markets. How are derivatives treated in bankruptcy? How is capital income and debt taxed? How are contracts and corporations set up and enforced? And so on.

The second level of regulation is "prudential" regulation. Prudential regulation of financial institutions is the various ways regulators regulate banks. Capital requirements are one example. So is prompt corrective action, restricting dividends for troubled firms, etc. One reason to do this for regular banks is to act as a coordinator for dispersed depositors who are unable or unwilling to perform these functions. Another is that financial firms have serious macroeconomic effects on the economy. And another is to intervene in issues of asymmetric information. The everyday libertarian case against regulating a restaurant is "who would want to poison their customers?" As we saw in the last 20 years, Wall Street is comfortable not only selling their customers poison at a high margin, but taking out life insurance on them through the credit swaps market.

The third level is blunter, and that's strict prohibitions, either on businesses or on size. What are the advantages and disadvantages of adding prohibitions? One factor is simplicity compared to other forms of prudential regulations, but what else is there?

Resolution

Adding prohibitions can help ensure the end of Too Big To Fail. In this sense it works to amplify, rather than replace, Dodd-Frank's resolution authority.

A common response is that the problem with Too Big To Fail isn't that the firms are too big or too complex, but too interconnected. Matt Yglesias notes that in the context of resolution, prohibitions aren't that important: "we can't put investment banks through the bankruptcy process because it's too systemically chaotic. In that case, Glass-Steagall is irrelevant and what we really need is a new legislative mechanism for the resolution of investment banking enterprises. That's what Dodd-Frank is supposed to do. This all just backs in to the point that even though the phrase 'too big to fail' has caught the public imagination, it's never been clear that size is relevant."

But here's Martin J. Gruenberg, Acting Chairman of the FDIC, in a big speech last Thursday:

While there are numerous differences between a typical bank resolution and what the FDIC would face in resolving a SIFI, I want to focus on a few key differences...

In addition, the resolution of a large U.S. financial firm involves a more complex corporate structure than the resolution of a single insured bank. Large financial companies conduct business through multiple subsidiary legal entities with many interconnections owned by a parent holding company. A resolution of the individual subsidiaries of the financial company would increase the likelihood of disruption and loss of franchise value by disrupting the interrelationships among the subsidiary companies. A much more promising approach from the FDIC's point of view is to place into receivership only the parent holding company while maintaining the subsidiary interconnections.
 
Another difference arises from sheer size alone. In the typical bank failure, there are a number of banks capable of quickly handling the financial, managerial, and operational requirements of an acquisition. This is unlikely to be the case when a large financial firm fails. Even if it were the case, it may not be desirable to pursue a resolution that would result in an even larger, more complex institution. This suggests both the need to create a bridge financial institution and the means of returning control and ownership to private hands.
Resolution authority is an untested solution for a financial firm, particularly one as large and complex as JP Morgan. Size and complexity make a difference. If financial firms were smaller and more siloed, there is an argument that resolution authority, which is one of the core mechanisms of Dodd-Frank, would work more smoothly and be more credible.
 
Market Power and Competition
 
As Barry Ritholtz noted on the JP Morgan loss, "Simply stated, once you are the market, you are no longer a hedge." Size makes a difference in these markets, and by breaking up the largest firms you'd see reduced market power. In terms of size, Andrew Haldane argues that economics of scale in banking top out at around $100 billion, or signficantly less than a 3 percent GDP liabilities cap. Beyond market power, the largest banks represent a large amount of political power as well.
 
And in terms of business lines, Kevin J. Stiroh and Adrienne Rumble, in "The dark side of diversification," look at financial holding companies as they absorb different business lines in the late 1990s and 2000s. "The key finding that diversification gains are more than offset by the costs of increased exposure to volatile activities represents the dark side of the search for diversification benefits and has implications for supervisors, managers, investors, and borrowers." New business lines introduce new profits but also introduce new volatility. The more volatile a firm is, the harder it is for it to fail without bringing down the financial system.
 
Mike Konczal is a Fellow at the Roosevelt Institute.
 
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