Band of Bigots: Dr. Sarrazin, Herr Henkel, and Bank of America

Sep 8, 2010William K. Black

euro_banknotes-150Calling on Bank of America to stand up to offensive ideas.

euro_banknotes-150Calling on Bank of America to stand up to offensive ideas.

On February 6, 2010, I wrote an open letter to Dr. Walter E. Massey, who was then Chairman of the Board of Directors of Bank of America. Dr. Massey is also President, emeritus, of Morehouse College. The context was that B of A has long retained Herr Henkel to create their team of senior business advisers for its operations in Germany. Henkel is a prominent German businessman who ran Germany's top business association (loosely equivalent to combining our Chamber of Commerce and Business Roundtable). Dr. Thilo Sarrazin's verbal assault on Arabs, Turks, and Muslims (and bizarre gratuitous claims about Jews) prompted my letter. Henkel issued a manifesto endorsing Sarrazin's claims. Henkel chose as his title for his manifesto a phrase that emphasized that he agreed with Sarrazin's attacks on Arabs, Turks, and Muslims and his bizarre statements about Jews without the slightest reservation ("without" any "if" or "but").

Henkel, independently, proceeded to blame the global financial crisis on loans to African-Americans and bemoaned the end of "red-lining" -- the deliberate discrimination by lenders based on race. Sarrazin had dismissed Arabs and Turks as capable only of working as "fruit and vegetable vendors." I wrote my open letter to Dr. Massey to remind him that B of A began as the Bank of Italy. The Bank of Italy was proud and eager to have Italian Americans who worked as fruit and vegetable vendors as its customers. I called on B of A to fire Henkel and review the team of advisors he had selected. I never received a response from any B of A representative and it appears that B of A continues to employ Herr Henkel and his team as its senior advisors in Germany.

Sarrazin is a major player in Germany. He is a member of the German central bank (and in the German context that is a far more exalted institution than the U.S. Federal Reserve). Moreover, Sarrazin is a Social Democrat, the major German party on the Left. The German central bank chastised Sarrazin for his prior rant and constrained some of his functions. Sarrazin, however, has now followed up with a book -- and public comments about its thesis -- that renew his attacks on Arabs, Turks, and Muslims. He also made new, equally gratuitous and bizarre claims about Jews. (He states that all Jews share certain genes. All humans share certain genes. Actually, all humans and all potatoes share some genes. And this proves what? That each of us, including Sarazzin, is a Kartoffel Kopf?)

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The German government appears to be getting ready to remove Sarazzin from the central bank. That is a big deal. Germans take pride and comfort in their central bank's independence. It is very difficult under their system to remove a member of the central bank. The difficulty is compounded because the party in power is the rival party to the Social Democrats. Removing Sarazzin will be deeply embarrassing to the Social Democrats. But the greatest difficulty is that many Germans agree with Sarrazin.

Germany's senior leaders are willing to take extraordinary, painful steps to end the disgrace that Sarazzin has brought upon the central bank and the nation. B of A, by contrast, can fire Henkel for cause, save money, and receive far better business guidance on lending from non-bigots. Only a handful of Americans share Henkel's nostalgia for the return of red-lining. So, what is B of A's excuse? Does Henkel's bigotry represent the values of B of A's senior leadership in Germany and the United States?

Americans and Germans share a great history with terrible dark aspects. We know our histories. We know how disastrously bigotry ends if it is not stopped. We know that bigotry is built on lies and that scientific racism is an oxymoron propagated by regular morons.

William K. Black is an Associate Professor of Economics and Law at the University of Missouri-Kansas City. He is a white-collar criminologist and was a senior financial regulator. He is the author of The Best Way to Rob a Bank is to Own One.

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Still Too Big to Fail: A Crisis in the Works

Aug 27, 2010Wallace Turbeville

stockmarket-1500001 The Dodd-Frank bill won't be enough to stop Wall Street from risking it all and plunging us into another financial crisis.

stockmarket-1500001 The Dodd-Frank bill won't be enough to stop Wall Street from risking it all and plunging us into another financial crisis.

On August 26, the New York Times joined other, nimbler media in reporting that Wall Street banks were working to frustrate the intent of the financial reform legislation. Proprietary trading (or, more precisely, its Avatar) has appeared in the form of client transactions which allow the banks to take risk-based market positions. It is the same behavior and the same traders, but in a different department.

Everyone who is surprised that Wall Street is beavering away to circumvent reform is invited to my next Saturday night poker game.

Revival of proprietary trading in technically defensible forms is unlikely to be the only tactic they devise. These traders are quite the clever guys and gals.

This prompts a question: If risk-based trading for account of the profit and loss of the banks lives on, did Dodd-Frank do enough to address the systemic risks known as "Too Big to Fail?" The answer is "no." Systemic risk is inevitable. It can only be mitigated by capital requirements, limitations on risky behavior and procedures that might minimize chaos and more fairly allocate losses if a disaster occurs. These measures help, but there will always be an element of risky behavior encouraged by access to the government funds in an extreme circumstance. As long as banks are big and interconnected, failure might well be intolerable. The best answer is to prohibit imprudently risky behavior, or at least make it less profitable.

Luckily, there will be opportunities to further mitigate systemic risk in the coming months. In particular, Barney Frank has announced hearings for this fall on financial sector compensation. These hearings may provide a productive opportunity to revisit TBTF.

The noble efforts by progressive members of congress to limit the size of financial institutions were probably doomed from the start to failure. The Administration, the Fed and congressional leadership were fixated on the belief that size enhances competitiveness, profitability and, therefore, security against failures. This, of course, ignores that the failure of a large bank, by itself, is more cataclysmic than the failure of a small one.

However, the greater issue has always been a function of inter-connectedness of the modern financial system. Financial institutions are a bit like the Borg from Star Trek, a race of apparent individuals who actually function collectively as a hive. Banks appear to be discrete businesses, but there are so many interbank transactions and obligations that a single default can easily start a chain reaction. The real problem is less "Too Big to Fail" than it is "Failures too Damaging to Permit."

Interbank transactions are essential. A primary purpose for banks is to facilitate free flows of money throughout the economy. A bank failure becomes a systemic problem when it causes the flow to stop out of fear that other banks might fail. Panics like this occurred in 1907 and in the Great Depression, and institutions like the Federal Reserve and the FDIC were established to address the risk. Nonetheless, it happened again in 2008.

Financial institutions are far less likely than other businesses to decline slowly into failure. Liquidity (ready access to cash) is essential to a bank. It provides credibility that the bank can meet the many obligations which are its stock-in-trade. A bank's liquidity can evaporate instantaneously. If one source of liquidity develops doubts and reduces or eliminates credit availability, the other sources will often follow suit creating a death spiral. Facts are often less important than rumors. The proximate causes of the Bear Stearns and Lehman failures were more widespread rumors than demonstrable facts.

Trading activity poses the greatest risk to liquidity. The need for cash is large (theoretically infinite for most derivatives) and immediate. Recall that the axe fell on AIG when Goldman and other counterparties demanded cash collateral in amounts far beyond that which could be funded. They were concerned about the risk of future losses, not current ones.

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Because failure can strike a financial institution like a lightning bolt (especially one significantly involved in trading), the insolvency resolution provisions of the Dodd-Frank legislation cannot be the complete answer. These provisions can forestall panic among banks if one or more becomes troubled; and it certainly helps to restore order after a failure by providing sensible options. But interbank panics can be as uncontrollable and difficult to predict as an earthquake.

The inescapable truth is that the best way to address TBTF is by curbing risky behavior, principally trading. The financial sector will resist this by defending every trench and employing every tactic. Given the enormous trading volumes and the scope of derivatives traded, the opportunity to generate unbelievable profit is simply too large to abandon. Superior information technology, market intelligence and liquidity (as well as several less savory practices available to Wall Street) constitute advantages with which most market participants cannot compete. Trading is like printing money for these institutions, until they inevitably make a mistake and lose even more in one fell swoop.

Among the several tools available to regulators to curb imprudent risk-taking (capital requirements, margin, disclosure), compensation reform may be the most direct and effective. Anyone who has spent an appreciable amount of time observing a trading desk will conclude that sober maturity is not a trait common among traders. (That is not a criticism. Sober maturity would undoubtedly impede their job performances.) Because profits from trading under advantageous conditions are so immense, the magnitude of performance based bonuses has become an embarrassment. For a 30 year old, overly aggressive trader, this is like holding a bloody steak in front of a lion. It is likely to encourage risky and dangerous behavior.

The trader is behaving rationally: the immediate rewards probably do outweigh the uncertain future risks. Fault lies with the regulations and with unwise and short-sighted management (which may well not understand fully the complex risks taken on by traders).

Compensation reform will be resisted as unfair. Shouldn't performance be rewarded? But much of the profit is reflective of inherent trading advantages rather than the skill and aggressiveness of the individual traders. I would hope that, in light of the financial crisis, we all agree that these advantages exist at the pleasure of the body politic. It would be completely defensible if, for instance, the financial institution's tax deduction for trading performance based bonuses were limited.

It will be said that curbing compensation will squelch innovation. I suspect that even reduced compensation provides plenty of incentive. More to the point, all innovation is not beneficial. It is clear that, in derivatives trading, innovation has far exceeded social utility.

Hopefully, Congressman Frank's hearings will be more than political show in an election year. He needs to consider the compensation of the leading executives. After all, these Captains of the Universe failed to see the inevitable failure of a market based on constant appreciation of residential real estate in an environment of stagnating and declining middle and low incomes, the principle determinants of home values. But trading performance based compensation needs attention as well. I begrudge no trader his or her second vacation home. But a second vacation retreat from the pressures of the trading floor cannot be justified if it is purchased by the presumed availability of the public treasury to cover the losses when the quantitative analysis turns out to be flawed.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co. He is Visiting Scholar at the Roosevelt Institute.

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Defanging Already Weak Financial Regulation

Aug 26, 2010Jeff Madrick

Prop trading is alive and well despite the Volcker Rule, and it will continue to cost us dearly.

Prop trading is alive and well despite the Volcker Rule, and it will continue to cost us dearly.

I sure hope somebody is going to notice the fine piece on the front page of Thursday's New York Times about how easy it is to get around the Volcker rule. Remember how the Obama team that came up with its reregulation proposals seemed to push Paul Volcker aside? The former Federal Reserve chairman was supposed to be running a committee on the subject for the president, but even he let it be known no one was talking to him much. Volcker was concerned that commercial banks were using insured depositor money to make risky investments and to drive huge bonuses -- and the Fed and the FDIC would be left picking up the pieces. The system should not be bearing that much risk, he wisely figured. And to be fair, he had long felt this way.

After an earlier front page Times piece by Lou Uchitelle on Volcker's concerns, Obama suddenly embraced a limitation on such trading -- the Volcker rule. There were many Volcker photo ops. There would now be a ceiling on what trading could be done for the banks' proprietary accounts -- its own assets. The Dodd-Frank bill embraced the idea. Problem solved.

No way, of course. The trouble is, banks have been trading for their own accounts to one degree or other for decades while making markets for their customers. In the late 1970s and early 1980s in particular, they first discovered they could generate big profits if they bought extra securities (or derivatives) at propitious times under the guise of keeping inventory to facilitate trades of their investors and corporate clients. They could also hedge their positions by selling. In truth, it wasn't even a disguise. They gambled money, but like all market makers, they had an insider's edge. And they made fortunes. Some of the investment bankers, in particular, loved the traders who took the big risks.

Of course, occasionally, they lost big -- and some of the losers made headlines. But mostly they made out like bandits. Over time, the lucrative practice was moved to the "proprietary" desks. That's where Howie Hubler lost $9 billion in a mammoth mortgage transaction for Morgan Stanley, as reported by Michael Lewis in The Big Short. I was never clear why the press didn't make more of that after Lewis divulged the unpublicized catastrophe. No one ever lost that much money on a trading desk before. Once not long ago, if you lost $200 million it was a scandal.

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Now Nelson Schwartz and Erich Dash have put their finger on what seemed to be hidden from view. The banks do a lot of this all the time, and they are doing it big-time again, the reporters found out. As they quote one consultant, "You can use client activity as a cover for basically anything you are doing." And the fact is that they do, and have done so for a long time. As the Times reporters write, "For all the talk of shutting down trading desks and reassigning employees to prepare for the Volcker Rule, proprietary-style trading will probably survive, if under a different name."

So much for the Volcker rule. And the great man himself (that is, Volcker) never came to grips with this immense hole in the regulations, either. High risk on Wall Street will go on.

Meantime, Sheila Bair found it necessary to argue in this week's Financial Times that stronger capital requirements will make the financial system better -- that is, help allocate capital where it is actually needed and useful. She apparently feels she has to defend higher capital requirements against influential complaints coming from the powerful financial community that they will undermine lending and raise interest rates. Yes, and regulations to limit oil spills will raise gas prices, higher wages will undermine corporate profitability and capital investment, and product safety standards will limit the number of toys parents can buy for their kids. Industry goes on and on. As if, suggests Bair, the earlier inadequate capital requirements resulted in no financial or social cost. Consider the credit crisis and the recessionary aftermath.

The financial reregulation package was never strong enough, but the battle to make work even what was passed, will go on. Nothing is quite so irksome as the financial community talking about how little TARP cost taxpayers as banks paid back their bailouts. First, TARP should probably have made money, like Warren Buffett will on the money he lent Wall Street. But second, the big cost is severe and ongoing recession resulting in hundreds of billions of dollars of lower federal tax revenues for years, unemployment rates near ten percent, and weak capital spending. Let's keep straight how much financial excess has and will continue to cost America.

Roosevelt Institute Senior Fellow Jeff Madrick is the author of The Case for Big Government.

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Shock Doctrine and Fire Sales

Aug 23, 2010Joe Costello

public-private-sign-150How the banks are reaping profits off the misery they created.

public-private-sign-150How the banks are reaping profits off the misery they created.

Foreman was a panic about to go in the insane
Trying to get the workers out the way of the train
Engineer blowing the whistle long and long
Can't stop the train had to let it roll on
-- Let It Rock, Professor Chuck Berry of St. Louis, Mo

A couple years ago, Naomi Klein wrote a book called The Shock Doctrine. She documented the global pattern of the last few decades where a nation hit with a crisis -- natural, financial, political -- would become open game for Randian, Friedmanite, University of Chicago sociopaths. They would insist on fire sales for public assets, placing society further under the control of mega-corporations and the local looting class. Asia, Russia, South America, and Africa: the paradigm and documentation was distressing. Today's Wall Street Journal article on the fire sale of local government assets across the US demonstrates that the Shock Doctrine remains alive and well, while the dominant economic doctrine of the past three decades, the worship of sociopaths, remains firmly entrenched.

The Journal's story begins:

Cities and states across the nation are selling and leasing everything from airports to zoos -- a fire sale that could help plug budget holes now but worsen their financial woes over the long run.

California is looking to shed state office buildings. Milwaukee has proposed selling its water supply; in Chicago and New Haven, Conn., it's parking meters. In Louisiana and Georgia, airports are up for grabs.

About 35 deals now are in the pipeline in the U.S., according to research by Royal Bank of Scotland's RBS Global Banking & Markets. Those assets have a market value of about $45 billion -- more than ten times the $4 billion or so two years ago, estimates Dana Levenson, head of infrastructure banking at RBS. Hundreds more deals are being considered, analysts say.

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Let's not forget who is in the middle of all these deals -- Wall Street. Here you have a list drawn up by the Royal Bank of Scotland, one of the biggest pigs in the pen, recipient of one of the largest bailouts in history, now listing US public assets on the block for cheap. Follow the whole storyline. Wall Street, with a great deal of criminal fraud, tanks the US and global economy, gets bailed out by your tax dollars, and continues to survive largely through cheap Fed money and other public subsidies. Instead of anyone going to jail, they go on a shopping spree with your money, buying your public assets made cheap by the economic collapse they engineered. There you go folks, that is the US economy in 2010. If you can tell me how its any different than mob activity, aside from the fact that no one goes to jail and it's much, much more lucrative, let me know. Don't forget, all this is aided and abetted by YOUR elected officials.

In one of the better notes of our public officials' culpability, look at a must watch interview (h/t zero hedge) with former Fed Governor Fred Mishkin, who was paid $124,000 to write a paper on how Iceland was the picture of financial stability a year before the whole thing crashed -- good work if you can get it.

Finally, Doug Noland has a good piece in the Asia Times on the last bubble, sovereign debt. John Hussman has another good piece on whether the Fed can tank the dollar with their next round of QE. Remember, the Royal Bank of Scotland said a couple months ago, it needed to be ten trillion dollars. That should do it! My advise: hold off on purchasing US public assets. The deals haven't even started.

Let it Rock.

Joe Costello was communications director for Jerry Brown’s 1992 presidential campaign and was a senior adviser for Howard Dean’s effort in 2004.

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Derivatives Clearing: At the End of the Beginning

Aug 23, 2010Wallace Turbeville

bank-vaultAn SEC/CFTC roundtable exposes how little is being done about the next financial time bomb.

bank-vaultAn SEC/CFTC roundtable exposes how little is being done about the next financial time bomb.

Just after the first Allied victory of the Second World War at El Alamein in Egypt, Winston Churchill spoke to the House of Commons: "Now is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning."

Any doubt that this aptly describes the circumstances following the passage of financial reform was erased by the public roundtable sponsored by the SEC and CFTC on August 20. The topic was "Governance and Conflicts of Interest in the Clearing and Listing of Swaps," and it was held in order to "assist both agencies in the rulemaking process" in implementing financial reform.

The primary news to report from the roundtable is that there are indeed conflicts of interest and significant governance issues. Some of us have been writing about these issues for months, and it was perversely rewarding to hear that they are freely acknowledged by the industry. What remains to be resolved is the matter of what, if anything, can be done about it.

During the roundtable, there were several complaints about the structure of clearinghouses. They have clearing members, mostly banks. Customers do not transact with the clearinghouse. They access clearing through the clearing members. The complaint was that it was difficult to become a member of the club. According to the complainants, the clearing members (dominated by ten or so large financial institutions) block new memberships. Clearinghouses used to be owned by the clearing members and were operated like public utilities, serving the interests of the members, but they went public over the last few years. It is widely known that the clearing members still exert great influence through their control over volume and revenue as well as participation in key decision making. Less has changed than might be expected from the transfer of ownership to public shareholders.

The first major topic addressed the methods of determining which derivatives can be cleared and which cannot. Derivatives that can be cleared fall under the new legislation's clearing requirement. It was acknowledged that rather than eliminate the risk of derivatives trading, the clearing process transfers and concentrates default risk in the clearinghouse. The risk is peculiar in that there is no cap on it. If you loan money to someone, you can only lose the principal. If you buy a stock, you can only lose the price paid. With almost all derivatives, there is no such limitation.

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Clearinghouses provide a central and transparent methodology for managing risk. This management system is the trade-off for concentration of risk. But risks cannot be managed if they cannot be measured. This means that the current value of the swap, defined as the price at which a replacement transaction could be executed immediately, must be known. It also means that the clearinghouse must be able to estimate how much it might lose if it took some time to replace the swap. This is measured statistically using historic market price moves and multiple assumptions.

It was also acknowledged that there are many derivatives for which risks cannot be measured. These derivatives cannot be cleared without creating imprudent systemic risk at the clearinghouses. One could sensibly question whether banks should be entering into transactions if the risks cannot be measured with sufficient accuracy to justify clearing. But the roundtable focused on the influence of banks on the question of what is clearable and what is not. If banks do not want a category of derivatives cleared, could the clearinghouses be influenced inappropriately to "err on the side of caution"?

Several points were raised on the topic:

• The clearinghouses acknowledged that the dealer banks have a great deal of influence. As clearing members, they sit on the all-important risk committees and assist the clearinghouse officials in shaping new cleared products.

• The clearinghouse representatives justified this influence because the clearing members are at risk if the clearinghouse defaults. Clearing members put up the default reserve funds that would be tapped to cover losses. They would have to participate in covering off a default. As a result, they deserve a say in the decision to clear a class of derivatives. Nobody pointed out that the American taxpayer is also at risk, as demonstrated by the financial crisis. If clearinghouses might be Too Big to Fail, shouldn't the government also participate in the risk committee process?

• One industry participant made the point that cleared derivatives are just as profitable as uncleared derivatives. Why would the banks ever resist expanding the scope of clearing? I wonder what the fight was about during debate of the Dodd-Frank bill. In fact, banks may prefer that clearing be available for certain derivatives. After all, they may have used up all available risk capacity for specific counterparties and cannot transact bi-laterally. A clearinghouse guarantee may be required to transact with that counterparty. But it is clear that they do not want clearing mandated. I think it may have something to do with profits.

The roundtable moved on to the possibility that clearinghouses might be tempted to imprudently clear some classes of swaps as they compete for market share. This may appear to contradict the prior concern, but it does not. Clearinghouses could be discouraged by banks from clearing some types of derivatives even when the risks are acceptable, and still imprudently clear other types. The fact is that clearinghouses have been acting imprudently for the last few years; the financial crisis simply did not involve their activities. It is a real problem, but no solutions were suggested.

Ownership and board seats were then discussed. The subjects of influence were the same; the methods for exerting influence were different.

A representative of JP Morgan said that his firm fully supported the concept of government-owned and fully guaranteed clearinghouses. I hoped that someone would inquire as to JP Morgan's position if the italicized language were deleted. But the fact is that the meaningful clearinghouses are, or soon will be, Too Big to Fail. The gentleman from JP Morgan raised an excellent point. Clearinghouses should be publicly-owned utilities, whether guaranteed formally or not. If anyone in government with the courage to support such a notion can be found, this is really the only sure answer to the questions raised at the roundtable.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

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Mike Konczal Goes to Treasury

Aug 20, 2010Mike Konczal

On Monday I took part in a blogger meeting with several members of the Treasury Department. Alex Tabarrok has a writeup, as does Yves Smith and John Lounsbury has an extensive one as well.

First off, here's a picture of me with Robert Rubin's portrait:

mike-konczal-2-100Getting some (sort of) straight answers from Tim & co.

On Monday I took part in a blogger meeting with several members of the Treasury Department. Alex Tabarrok has a writeup, as does Yves Smith and John Lounsbury has an extensive one as well.

First off, here's a picture of me with Robert Rubin's portrait:

Second, have you ever seen Miracle on 34th Street? Remember at the end when that guy legally is Santa Claus because he has all that mail delivered to him? I felt a little like that seeing "Mike Konczal, Rortybomb" on paper that had Treasury's seal:

Heh.

It was a pretty casual meet and greet. There weren't any presentations, nothing to be sold on. We went to questions immediately. Geithner is very smart and personable, and it was very useful to chat with Treasury officials on background over the strengths and weaknesses of the financial reform bill.

Notes

Here are some of my notes from the meeting:

- My first question was that since we have clear conceptual metrics for how to judge the success of the other major policy achievements of the Obama Presidency like the stimulus (jobs created/saved) or health care (coverage, bending the cost curve), do they have internal metrics for successful implementation of the financial reform bill? I don't think we have those metrics well-defined for financial reform (percent of derivatives clearing? liquidity reserving?) and as such it will be harder for the public and experts to define what a successful implementation of the bill will look like.

They didn't have much in terms of goalposts. They pointed out that the big battlegrounds for rule-writing will be determining whether a firm is systemically risky, derivatives clearing and FDIC's resolution. (Those are the major features of the bill, FYI.)

- They were very optimistic about Basel. They think it is moving faster and will come online with fewer conflicts than most appreciate. There will be a binding international leverage ratio. We weren't told what it would be (they seemed surprised that we asked).

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Shadow Banks, Resolution

- Tyler Cowen beat me to bringing out the shadow banking market questions, with a pointed question about money market mutual funds. I followed up by asking whether or not Perry Mehrling style reform, serious structural backstops, dismantling or narrow banking reconfiguring of shadow banks was needed.

Treasury in general thought that the buffers and new capital requirements would be more than enough to handle any problem resulting from shadow banking. Treasury brought up, when the Mehrling-style thought was invoked, how they didn't want to live in a country where the government steps in to backstop the shadow banks. Steve Waldman yelled out "you already live in that country!" It was pretty funny.

There's a money market mutual fund report coming out sometime soon that I'll have to keep my eye out for.

- Treasury said they were disappointed that people covering the bill didn't emphasize a 10% cap on liabilities of a firm as a percent of all liabilities. Someone mentioned that two firms might feel a bit of heat right out the door. I've never heard that the liability cap portion of the bill was meant as an actual mechanism to block a level of concentration; indeed I'm used to hearing glowing things about Canadian banking and having a handful of very high-level banking-sector concentration being meme-dropped from the White House. I'm going to look into this next week and will write more.

- They used the phrase "level-playing field" a lot. They also said "finreg" for the financial reform bill and process.

- I mentioned that resolution authority may not be credible on the five biggest firms, and that this may distort the way the bond market interacts with a worse case scenario that we'll end up with a Too Big To Resolve problem. Biggest banks are all bigger than at the beginning of the crisis, and so forth. I mentioned Shahien's story about Moody's difficulties on ratings the Too Big To Fail firms post-bill and what they thought of that too. They generally took a we'll wait and see approach. Yves Smith jumped in here on the international components to resolution; again, same approach. They are optimistic about the markets taking resolution and regulation seriously.

HAMP

- They are sticking by HAMP. The narrative seemed to change from helping homeowners to spacing out the foreclosures. I asked them to repeat it, because the idea that billions of taxpayer dollars are being spent to smooth out foreclosures for banks struck me as new narrative -- it's explicitly extend-and-pretend, and also fairly cynical.

- There was talk about how fiscal policy can't move through Congress. I asked them about only 0.5% of HAMP being spent and how that could be used without Congress' permission. Before I suggested that the remainder of the $50 billion be divided into two funds, the Digging Holes Across States (DHAS) fund and the Filling Holes Across States (FHAS) fund, two far more socially productive means of spending the HAMP money than what is currently being done with it, I was told that the entire $50 billion is expected to be spent by the time the program is over. I didn't believe it; we will see.

- Overall, there seemed to be a sense of "we are done here" from the meeting. Maybe it was the factors that it is August, the informal manner of the meeting and a news cycle that is driven by insane things, but there was a sense with the financial reform bill passed, deadlock in Congress and a Federal Reserve tip-toeing around its mandate things were going to slow down and options are more or less removed from the table. Which is a very scary thought with the economy the way it is.

Mike Konczal is a Fellow at the Roosevelt Institute.

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The Myth of the "Credibility of Markets"

Aug 19, 2010Marshall Auerback

marshall-auerback-100It is time to distinguish between the truths and the myths propagated by Wall Street.

marshall-auerback-100It is time to distinguish between the truths and the myths propagated by Wall Street.

A few days ago, I wrote a piece suggesting that President Obama's attack on the proposed GOP threat to Social Security masked a more fundamental threat posed by members of his own party.  Sadly, this analysis appears to be confirmed today in Mike Allen's politico playbook:

"--ADMINISTRATION MINDMELD: The virtue of action on Social Security is that it demonstrates the ability to begin to affect the long-run deficits. Social Security isn't the biggest contributor to the problem - that's still health-care costs. But it could help a little bit, buy time, and strengthens the odds of a political consensus behind other spending cuts or tax increases. Most importantly, it would establish more CREDIBILITY with the MARKETS. The mood of the world at the moment (slightly excessive, from the administration's point of view) is that if you don't do anything with spending cuts, it doesn't get you credibility." (My emphasis).

 

This, in a word, encapsulates the Administration's perverse Wall Street-centric thinking.  Credibility with the American people takes a back seat to this amorphous concept called "the markets", and the corresponding need to maintain "credibility".

But how are we to divine the true aspirations of the markets?  Is this really a legitimate basis for government policy?  Private portfolio preference shifts (which are manifested daily in the capital markets) are probably the area least amenable to economic analysis.  There are no cookie cutter models here (and economists LOVE models).

Consider the case of a currency: How does one respond to a weaker currency?  The conventional response seems to be, "Raise interest rates and eventually you'll re-attract the capital because you will re-establish 'credibility' with the markets". That was essentially the IMF advice to East Asia in 1997.  But, as that experience demonstrated, sometimes raising rates can actually trigger additional capital flight if it is perceived to be a panicked reaction to something.  And Japan today clearly demonstrates that low rates per se do not necessarily prefigure a weaker currency. What does a 10 year Japanese government bond yielding less than 1% tell us about "the markets"? Does it reflect approval with a country that has a public debt to GDP ratio about 2.5 times higher than the US?

To paraphrase Milton (the poet, not Friedman), sometimes they also serve who only stand and wait!

Markets are an amorphous concept, which reflect heterogeneity of viewpoints.  Some people today are buying gold because they foresee a Weimar style hyperinflation emerging in the face of all of this government spending. Some buy it because they envisage the death of fiat currencies and view the yellow metal as the ultimate insurance policy.  Some invest because they consider gold the only real form of money.  Some people view it as a barbarous relic and ignore it altogether. How does a government respond to these varying points of view?  What's the right policy response?

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The myth that markets, not governments, ultimately determine rates has, of course, been legitimized to some degree by virtue of the fact that our institutional monetary arrangements still reflect archaic gold standard type thinking (whereby a certain amount of gold on hand was required to fund government operations).  But we went off the gold standard decades ago. Still we have laws which mandate that all net government spending is matched $-for-$ by borrowing from the private market. So net spending appears to be "fully funded" (in the erroneous neo-liberal terminology) by the market. But in fact, all that is actually happening is that the Government is coincidentally draining the same amount from reserves as it adds to the banks each day and swapping cash in reserves for government paper.The resultant bond market drain is there to ensure that the central bank maintains control of its reserve rate.  It has nothing to do with "funding" government operations itself.

If you think that sounds radical then consider the following question posed by my friend, Professor Bill Mitchell:  If a government bond auction "fails" (i.e. the government doesn't find enough buyers for the paper it issues during that particular sale), does this mean that your Social Security cheque is going to bounce?  Will national infrastructure projects be suddenly halted because the net spending is not "funded"? Do we have to stop fighting a war in Afghanistan?  The answer to all of these questions is the same: Of course not!  The net spending will go wherever the Government intends it to go - after all the Government needs no funds to spend because it first creates the currency which is ultimately required to be spent in the real economy.  The private sector does not produce dollars (if it did, it would represent a jailable offence called counterfeiting).

More fundamentally, how, pray tell, does one presume that the private sector can net save (in this case, dollars) something it cannot net produce?

Isn't it true that the government is in a unique position because only it has the capacity to create new net financial assets?  Now, granted, this simple observation does not readily apply to the euro zone because the individual countries concerned have effectively ceded that authority, thereby circumscribing an adequate fiscal response to their crisis (a point I have made before).  But when the operations of government are examined in this light, it establishes that the Obama Administration's ongoing fixation with "long term deficit reduction" and "establishing credibility with the markets" is as foolhardy as conducting human sacrifices to placate a deity.

Yet government policy responses today on issues like Social Security or Medicare reflect a misguided belief system and a genuine failure to understand the basis of modern money.  Scaling back Social Security will certainly drive unemployment up higher than it is already going becomes it robs people of the very income required to sustain growth. Not a very sensible strategy if you truly care about implementing "change that people can believe in".

Unfortunately, until these Wall Street-centric beliefs are fully exposed for the myths that they are, we can expect to see more dispiriting headlines of the sort reflected in Mike Allen's latest politico playbook.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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Mel Brooks and the Bankers

Aug 19, 2010Thorvaldur Gylfason

the-producers-original-motion-picture-soundtrackMel Brooks's The Producers offers clever insight into the origins of the current financial crisis.

the-producers-original-motion-picture-soundtrackMel Brooks's The Producers offers clever insight into the origins of the current financial crisis.

In Mel Brooks' brilliant film and Broadway musical The Producers, an over-the-hill Broadway producer, Max Bialystock and his hapless accountant, Leo Bloom recognise two great truths. It is very hard to produce a hit and very easy to produce a flop - and they can make more money by producing a flop than by producing a hit. Max uses his expertise to ensure that the play flops. He selects the worst play ever written (Springtime for Hitler) - an ode to Hitler, a terrible director, and an awful male lead. Max understands critics' key role in determining the success of Broadway plays, so he pretends to attempt to bribe the most prominent critic in order to enrage him and make sure that he will pan the play.

Max then (literally) seduces his investors, raising a million bucks from "little old ladies" by selling far more than 100% of the potential profits. If the play fails almost immediately, the investors will not expect to receive any money and Max and Leo can run away to Rio with the investors' money.

The plot fails, however, because the show turns out to be a hit. It is so excruciatingly bad that the audience assumes it is a clever satire. Bialystock and Bloom land in jail when they are unable to pay over 1000% of profits to the investors. In prison, Max and Leo promptly set out to try the same scam. The story ends there because even Mr. Brooks could not imagine what happened next.

Real-life Bialystocks and Blooms

Not all the CEOs running the fraudulent savings and loans (S&Ls) in California and Texas in the 1980s and 1990s saw The Producers, but all of them could have played Max's role convincingly. They shared Mr. Brooks' insight into why the massive frauds use accounting as their "weapon of choice", structure their efforts to fail, and recruit an accountant as their most valuable fraud ally. The fraudulent CEOs and their accounting allies were the real-life Bialystocks and Blooms. They bankrupted the S&Ls, enriching themselves and their friends along the way, at the expense of stockholders, creditors, and taxpayers.

Fraudulent lenders maximise their (fictional) income by making exceptionally bad loans and growing very rapidly. Borrowers that will frequently be unable to repay their loans are numerous (allowing the lender to grow rapidly) and will pay a higher interest rate (yield). The combination of rapid growth and high interest rates produced guaranteed, record income in the near term during the S&L debacle and the current subprime lending crisis.

During the ongoing subprime mortgage loan crisis, the rating agencies and the top tier audit firms played the real life role equivalent to the critic that Max pretended to try to bribe to make sure that Springtime for Hitler received a terrible review. Unlike the critics, who Max realised he could not succeed in bribing, the rating agencies and the top tier audit firms gave rave reviews to toxic subprime mortgage paper. The rating agencies claimed the toxic waste was pristine "AAA" - the safest of the safe. The elites that we count on to advise us on quality in the real world are more corruptible than the elites in the fictional world that Max and Leo inhabited.

In the words of Professor Paul Romer (quoted from Johnson and Kwak 2010), "Over the last fifty years, the Federal Aviation Administration, the airline manufacturers, and the airlines worked together to make a highly complex air travel system more efficient and much safer... in contrast, our financial regulators and banks have made our financial system less efficient and much more dangerous."

In time, the regulators and the American justice system caught up with the S&L frauds. More than a thousand priority white-collar felony convictions resulted from the S&L debacle. Also, high-ranking politicians who had aided and abetted the S&L operators and accepted donations from them were driven from office and power, including Jim Wright, Speaker of the House of Representatives from 1987 to 1989. The "Keating Five" were deeply embarrassed for their intervention on behalf of the most notorious fraud, that perpetrated by Charles Keating at Lincoln Savings. One senator was reprimanded by the Senate Ethics Committee, another two were criticised for acting improperly, and two more, while cleared of impropriety, were criticised for poor judgment, including Senator John McCain, the former presidential candidate.

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Repeated Games

But this is a trick you can pull only once, you might think. Well, a few years later the people in charge at Enron thought they might try something similar, and for a while it looked as if they might succeed. Their fraud was exposed as well, however, and they brought down with them Arthur Andersen, one of the big five accounting firms in the US. And then there was WorldCom, and hundreds of others. Prosecutors were able to arraign only the most notorious of these frauds.

The crisis that started in 2007 also contains significant elements of fraud. The crooks still understand Max and Leo's scam, but this time the regulators and prosecutors appear to be as clueless as the little old ladies that Max conned.

Perhaps we need to send the regulators and prosecutors to remedial showings of The Producers. Alternatively, we could have them become familiar with modern economics and white-collar criminology. Inspired by the experience of regulators who had dealt with the S&Ls and understood fraud - and perhaps also by Mel Brooks - George Akerlof, the Nobel-Prize winning economist, and Paul Romer published in 1993 a famous article entitled "Looting: The Economic Underworld of Bankruptcy for Profit." In 2005, the white-collar criminologist, economist, and lawyer William Black published a book entitled "The best way to rob a bank is to own one". Again, the title says it all. In an appendix, the book reproduces a memo from Charles Keating that reads, in part, "get Black - kill him dead." In the 1980s, Mr. Keating ran the Lincoln S&L Association, running it into the ground in 1989 at a cost to the federal government of over $3 billion and leaving about 23,000 customers with worthless bonds. Mr. Keating, a generous backer of the five afore-mentioned senators, the "Keating Five", served four and a half years in jail.

Built to Fail

Mr. Black has listed the four main characteristics of fraudulent banks.

  • They grow very rapidly;
  • They make really bad loans at high yields (because only borrowers who have no intention of paying back will borrow at exorbitant interest);
  • They pile up huge debts; and
  • They set aside pitifully small loss reserves.

This, in a nutshell, is what many of the failed S&Ls in California and Texas did in the 1980s. The key thing to realise is that such banks are built to fail. The owners and operators of the S&Ls could live lavishly as long as their scam lasted, or longer, as many of them, even after serving time in jail, walked away rich at the expense of innocent bystanders.

At some point, though, the threat of getting caught may lead some to try to subvert the law. As Professor James Galbraith put it in his testimony in the US Senate 4 May 2010, "This is where crime and politics intersect." This is where law and order enter the picture if financial regulation has failed to rein in the banks as it did before the onset of the current crisis in 2007. The National Transport Safety Board investigates every civil-aviation crash in the US. In Europe, national Civil Aviation Accidents Commissions perform this vital role. Their principal concern is public safety. For reasons of consumer protection and public safety, finance needs to be viewed the same way as civil aviation. When things go wrong, there is a clear need for credible crash analysis to secure full disclosure. If laws were broken, the public has a right to know. Mel Brooks would agree - Bialystock and Bloom went to jail.

Thorvaldur Gylfason is a Professor of Economics at the University of Iceland and a Research Fellow at the Center for Economic and Policy Research.

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Consumers, the Food Crisis, and Index Funds

Aug 18, 2010Wallace Turbeville

bread True believers may be ready to absolve the free market for the food crisis of 2007/08, but its victims deserve better.

bread True believers may be ready to absolve the free market for the food crisis of 2007/08, but its victims deserve better.

The financial reform legislation focused on systemic risk and protection of consumers of financial products.  Congress steered clear of trading behavior which is abusive or otherwise simply harmful to the public.  Perhaps this unfinished business will be addressed in round two of reform, assuming Congress has the stamina. Until then, it is up to the regulatory agencies as they implement the new law.

Fueled by information technology and deregulation, trading volumes have exploded in the last decade. The categories of commodities and financial instruments actively traded have multiplied geometrically, as more products are "derivitized" by banks and hedge funds. There are derivatives on prices for most components of a typical household's budget, everything from corn and wheat to gasoline and electricity.

What are the implications for American consumers as they shop for groceries, fill up at the pump and heat and air condition their homes? Those consumers, pounded senseless by predatory credit cards, unemployment and underwater mortgages, remember the price spikes and volatile markets of 2007/08.

And how were the poor populations of the developing world affected?  From 2005 to 2008, the real cost of food increased to the highest levels since 1845, according to the Economist. Wheat more than doubled in price. Real people went hungry.  An additional quarter of a billion people were relegated to the "food insecure" category by international agencies in 2008. The UN believes that American derivatives markets contributed to this crisis.

We owe these people an honest answer.

With the blind faith of religious zealots, the leading thinkers in and out of government came to believe that unfettered trading markets are bound to maintain efficient and fair price equilibrium.  Alan Greenspan, the high priest, was generous enough to share this doctrine in his memoirs and other writings.

Events suggest that this faith was misguided. Efficient markets are large, transparent and liquid. Inefficiencies are quickly squeezed out as traders react to take advantage. However, sophisticated traders have successfully segmented all markets by creating specialized derivative instruments and strategies. They prosper in less efficient environments of their own creation. The trading markets are by no means perfectly efficient.

Faith is resistant even to factual evidence. Self-proclaimed reformers still focus on the good health of the trading firms and curbing their propensity to self inflict wounds. They ignore the possibility that some types of trading are inherently detrimental to the public's welfare.

This is not a video game in which traders get to accumulate bonus pool points in an imaginary environment.  Real people experience misery on a wide scale when unintended consequences occur. If futures trading affected prices of food and fuel, the faith of the free market believers is called into question. This possibility must not be dismissed just because it is uncomfortable.

The OECD commissioned research by Professors Scott Irwin (University of Illinois at Urbana-Champaign) and Dwight Sanders (Southern Illinois University Carbondale). It examined "the role of index and swap funds in agricultural and energy markets." Commodities index funds were invented by Goldman Sachs in 1991, but rose to prominence as customer investment increased from $3 billion in 2003 to $260 billion in 2008. Commodities prices rose dramatically during the same period, increasing 71% on average from 2006 to 2008.

Managed by investment banks, index funds pool investor money to buy futures contacts on exchanges.  Funds invest exclusively in long positions, so contract values increase as expected commodities prices increase. The futures contracts are allocated among various agricultural and energy commodities in order to reflect overall commodities price movements.

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Futures contracts are priced based on market expectation of "spot" prices in "cash markets." The cash market is the purchase and sale on delivery of the actual commodity for a price, referred to as the spot price. Over time, futures contact values fluctuate with changing market expectations regarding future spot prices. As a futures contract expires on the delivery date, the contract's value converges with the actual spot price. (For reasons still not understood, convergence broke down at the height of commodities prices in 2008, just before the financial meltdown. This was and is considered to be exceedingly odd.)

A holder of an expiring future may be required by the exchange to actually make or take delivery of the underlying commodity. The purpose of the index funds was to track futures prices perpetually. Expiration and potential delivery were to be avoided. So, on pre-designated dates prior to the notional delivery month, futures contracts were sold off and replaced by purchases of futures with a later delivery date. This is referred to as the "roll."

The Irwin/Sanders study (labeled "preliminary") generally supports the notion that the index funds did not cause a commodities price bubble. Many believe that the study takes futures trading off the hook for the damage done by the commodities price run-up. It is a great comfort to the true believers in perfect markets. There are academic studies with contrary results. Some have criticized the Irwin/Sanders study's methodology and data sets.  I am in no position to dispute the methodology.

But I emphatically question the scope of the study and its failure to answer many questions. To me, it offers no answers to American consumers and hungry children in developing countries.

Here are some of the bases for the study's conclusions and my thoughts on them.

The study found no evidence that investment inflows into the funds caused price increases and volatility. Use of inflows as the purported cause of high spot prices and volatility is a problem. Obviously, when money flowed into funds, futures had to be purchased. But the far more significant issue is the periodic roll into longer-dated futures. Theoretically, at a roll date, the entire fund could be liquidated and reinvested in replacement futures based on subsequent cash market months. Like the Phoenix, the fund dies through liquidation and is recreated through purchases of a new class of futures.

Inflows were significant, but were spaced out over time.  Roll dates involved large sales and purchases in the market. Net long positions may not change on a roll date, but there is a lot of market activity in both currently expiring futures and longer-dated ones. The rolls should have been analyzed for causal relationships with spot price and volatility.

The study found that the trading patterns of the funds (i.e., the rolls) were predictable as to time and commodity class. If fund trading had strayed from fundamental values (prices determined primarily by supply and demand dynamics), other market participants would have traded against the funds to force prices toward these values. This phenomenon is a form of arbitrage. The study acknowledges that uninformed and unpredictable trading (referred to as "noise trading") may deter arbitrageurs. The uncertainty and chaos of noise trading increases the risk of trading based on fundamentals. Rational arbitrageurs can experience losses when noise traders randomly and irrationally move the market. The study acknowledges that, if arbitrageurs do not discipline the markets, futures prices can be de-linked from fundamental values and cash markets can be affected.

The roll procedure does appear to be the opposite of noise trading. But the study does not address the possibility that market participants may have employed trading tactics designed to take advantage of the pre-programmed need to roll large quantities of futures contracts across time periods on specified dates.  It is widely believed that this happened. (I would be flabbergasted if it did not). Index fund investors complained publicly about losses experienced on rolls during 2008. Tactical counter-trading could well have been the cause.

Traders using tactics were behaving rationally. But they based their behavior on futures contract supply and demand. They were unconcerned with fundamental value. Tactical counter-trading, de-linked from fundamental values, could deter arbitrageurs and influence cash markets, just like noise trading.

The study states: "Lack of convergence between spot and futures prices in certain markets, however, does raise issues a number of issues about the functioning of these markets and the possible role of index funds. Future research is needed to understand better..." The immediate implication of non-convergence was that futures contracts were not useful to real businesses trying to hedge their market price exposures. More importantly, convergence is a fundamental property of futures contracts. It is definitional. The occurrence of this phenomenon during the period prior to the financial meltdown is important evidence that something unusual was happening. Any study of the effect of futures on cash market prices is incomplete without an explanation.

Notably lacking from the study is consideration of the possibility that high futures prices and volatility may have affected fundamental values. Commodities producers and wholesale buyers must hedge their price risk using futures.  In high price and/or volatile markets, they have to post higher margin in order to hedge. During 2007/08, price levels and volatility in commodities markets were unprecedentedly high. Hedgers' operating costs and risks increased as a result. In fact, agricultural and energy hedgers panicked during this period because they could not arrange sufficient financing to post collateral. Costs and risks change fundamental values. That change feeds back into the expectations driving futures markets and the cycle repeats. Prices can spiral upward.

The study cites factors related to supply and demand that influenced prices during the period. (It is curious that the study did not discuss the onset of the US recession in 2007, which presumably dampened demand.) It also observes that prices of many commodities other than those traded by index funds increased.

Perhaps futures market trading had nothing to do with the real market prices for products, even though large increases in fund activity coincided with abnormally high prices and volatility. However, the issue is so important that skepticism of conventional beliefs, not faith in the perfection of free markets, is appropriate for any study of the issue. The American public and a hungry world deserve at least that much.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

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Elizabeth Warren, Rapping and Cowboy Hats

Aug 13, 2010

This made my Friday:

This made my Friday:


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