Collectively Bargaining for a Better World

May 19, 2010

line-of-american-peopleAccording to Stephen Lerner, it's time for union members to seize the day.

line-of-american-peopleAccording to Stephen Lerner, it's time for union members to seize the day.

"Now is the moment to change collective bargaining practices so you can take a larger role in social movements," writes Stephen Lerner in his article An Injury To All: Going Beyond Collective Bargaining as We Have Known It (full text below as PDF). Lerner wants to shake up the old models of unionization and build upon on the potential of the current economic climate. "This is the time to offer a moral voice for those devastated by the economic crisis," urges Lerner, "and to have the courage and passion to liberate ourselves from the straitjacket of limited expectations."

In this must-read piece, Lerner reminds us that "throughout history, labor's greatest growth and most significant impact has come when labor is part of a broader social movement." When unions began growing in 1935, they pressed for government regulations and programs that ensured the social safety net for themselves and other Americans. He sees a parallel in this today -- a chance for another organized, collective movement toward better business practices, based on the power of workers.

By banding with other unions and groups, Lerner sees the opportunity to transform industries like food processing, banking, trucking and health care. The finance sector, in particular, could benefit from grassroots opposition and reform. "Banks represent the most extreme example of the unsustainable disparity between those on top and the rest of us." By linking deregulation, abuse of workers and consumers, and the economic crash, unions can capitalize (no pun intended) on the current anger and work for "substantive" fixes to the current system.

This sea change in the way unions do business is not just necessary for the general public; it's necessary for the relevance of unions themselves. "If we don't seize the opportunity of the current economic crisis to chart a radically different course -- committing ourselves and our movement to organizing for transformative change -- we will sink into a deserved abyss of irrelevance." So it's time to get to work - the work of social change.

Read full text of An Injury to All as PDF.

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Traffic Snarls on K Street as Protesters Demand Reform

May 18, 2010Bryce Covert

raised-fist-150For the last year, the anger against the financial industry has been boiling, spilling over into protests in Chicago and on

raised-fist-150For the last year, the anger against the financial industry has been boiling, spilling over into protests in Chicago and on Wall Street. It continues to drive people to the streets, this time in Washington DC at a protest yesterday on K Street. K is home to lobbyists for big banks and other large corporations, and several thousand people showed up to highlight the influence of lobbyists in the financial reform debate and demand accountability for Wall Street. Protesters sat in the street, disrupting traffic at the intersection of 14th and K, while holding aloft a puppet of a lobbyist pulling the strings of a Congress member. The group later marched to Bank of America with a letter demanding changes to the bank's business practices.

The connection between the economic recession, unemployment, and the need for financial reform was on everyone's mind. "Let the big banks know that it is not OK to spend millions of dollars for legislation that protects the banks and forgets the people," one demonstrator said, recounting her effort to save her home from foreclosure.

"Wall Street and corporate special interests are the single biggest obstacle to the reforms working families urgently need -- from good jobs to Wall Street reform," said AFL-CIO Secretary Treasurer Liz Shuler. "The big Wall Street banks brought on the economic collapse that destroyed millions of jobs, they took billions in taxpayer bailouts and then they went right back to fighting meaningful reform."

The series of protests -- called "Showdown in America" -- are intended to stand in contrast to the outrage of the Tea Partiers, focusing their anger against the corporations that caused the meltdown instead of just the government. "Wall Street has taken over our economy. They are taking our jobs. We are losing our homes," said a demonstrator who lost her job last year after her manufacturing plant was purchased by a private equity firm. "We need to reclaim our rights."

"More and more Americans are making the connection between a broken banking system and a broken democracy," said Reverend Dr. Eugene Barnes, President of National People's Action. "[Banks and lobbyists] have hijacked our democracy, and we are here to take it back."

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Why Merkley-Levin Is Necessary

May 18, 2010Mike Konczal

A funny thing happened in June of 2007. Back when times were better, Bear Sterns had previously created two hedge funds, one in 2004 and one in August of 2006, named "Bear Stearns High-Grade Structured Credit Fund" and "Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund."

A funny thing happened in June of 2007. Back when times were better, Bear Sterns had previously created two hedge funds, one in 2004 and one in August of 2006, named "Bear Stearns High-Grade Structured Credit Fund" and "Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund."

As the New York Times explained it in June 2007, "...41 months of positive returns of about 1 percent to 1.5 percent a month. But investors were clamoring for even higher yields, which would require more aggressive bets on riskier mortgage-related securities and significantly higher levels of borrowed money, or leverage, to bolster returns."

So Bear Sterns put up $40 million dollars of its own money into these two firms between 2004 and 2006, and in June 2007, Bear had to bail out these two funds with a line of credit worth $3.2 billion dollars. A $40 million dollar upfront bet sponsoring a hedge fund ended up putting them on the hook for billions of dollars in losses. They got a nice trickle of returns for loading up on the tail risk, a great strategy that works until it doesn't.

And that's fine that they did that. The question is do we need banking firms that have access to the discount window, banking firms that receive FDIC insurance, the commercial banking firms that handle deposits and form the backbone of our lending and payments systems, to be making these bets? Should firms that are protected under the safety umbrella of commercial banking be making proprietary bets, bets that can go lopsided quickly and with devastating losses?

The Volcker Rule works under the assumption that they shouldn't. That these activities are great for hedge funds to go gamble with, but if you are a bank you need to be regulated like a bank, and part of that involves not running hedge funds that puts depositors and taxpayers at risk.

More than the Dodd Bill

Given that section 619 of the Dodd Bill makes provisions for Volcker Rule, why is the Merkley-Levin Amendment (SA 3931) necessary?

Section 619 right involves the Council of regulators, which includes (and will likely be overly influenced by) the Federal Reserve, Treasury and the OCC, would come together and do a study, and then decide what if any restrictions they want to impose. The bank regulators would then go about implementing them.

The problem is that the Council, the way the Dodd Bill is written, has very broad authority to determine what type of regulations they want to impose and what kinds of exemptions they want to give. It allows the Council can rewrite the rules as they see fit. The Section 619 language also doesn't have conflict-of-interest language at all.

A Floor, Not a Ceiling

Economics of Contempt has a critique that says that this amendment tries too hard, and that in defining what proprietary trading is it creates new loopholes that industry can drive through, and that regulators on the ground will have better knowledge of the specific ins and outs of what does and does not constitute proprietary trading. As EoC concludes: "People often ask why I say that complicated financial regulations can't be written at the statutory level. The reason, sorry to say — which Merkley-Levin demonstrates quite well — is that Congress sucks at writing complicated financial regulations."

The disagreement is over what constitutes a "permitted activity", what is allowed, and whether or not it is so broad regulators on the ground would be able to do better. I think Merkley-Levin is way ahead of this critique, and what EoC doesn't mention is that the bill provides for this. In case they excluded too much from permitted activities at the statutory level, regulators can add some provided it meets a certain threshold (p. 10):

‘‘(d) PERMITTED ACTIVITIES...(I) Such other activity as the appropriate Federal banking agencies, in consultation with the Securities and Exchange Commission and the Commodity Futures Trading Commission, jointly determine through regulation, as provided for in subsection (c), would promote and protect the safety and soundness of the banking entity or nonbank financial company and the financial stability of the United States.

If there are activities that could be justified in promoting safety and soundness, regulators can include them into the bucket of permitted activities. Note that this is a fairly high bar to hurdle, so regulators have to make a fairly good excuse to go for it. Now let's say that an element in the bucket of permitted activities is good in theory, but regulators want to be able to beef up requirements based on that element. In the amendment, regulators can increase their supervision of a permitted activity (p. 11-12):

(3) CAPITAL AND QUANTITATIVE LIMITATIONS.—The Board, in consultation with the Securities and Exchange Commission and the Commodity Futures Trading Commission, shall adopt rules imposing additional capital requirements and quanitative limitations regarding the activities permitted under this section if the Board determines that additional capital and quantitative limitations are appropriate to protect the safety and soundness of the banking entities and nonbank financial companies engaged in such activities.

Now that's in one direction. What if EoC's critique is correct, and that financial firms will be able to abuse a permitted activity in a manner intended to evade the requirements of the amendment? Well, the amendment allows the regulators to go after that:

(2) TERMINATION OF ACTIVITIES OR INVESTMENT.—Notwithstanding any other provision of law, whenever an appropriate Federal banking agency or the Securities and Exchange Commission or Commodity Futures Trading Commission, as appropriate, has reasonable cause to believe that a banking entity or nonbank financial company under the respective agency’s jurisdiction has made an investment or engaged in an activity in a manner that is intended to evade the requirements of this section (including through an abuse of any permitted activity), the appropriate Federal banking agency or the Securities and Exchange Commission or Commodity Futures Trading Commission, as appropriate, shall order, after due notice and opportunity for hearing, the banking entity or nonbank financial company to terminate the activity and, as relevant, dispose of the investment; provided that nothing in this subparagraph shall be construed to limit the inherent authority of any Federal agency or state regulatory authority to further restrict any investments or activities under otherwise applicable provisions of law.

Isn't that clever? "Regulators, you have to follow these rules, but if you want to make them stricter by all means go ahead."

Again, it's a floor, not a ceiling. This is a good solution for how to use the best that regulators can bring to the table without assuming they are perfect. I brought it up when talking about state consumer pre-emption. If you have two potential regulations, the smartest game theory move is to follow the strategy where you always pick the stricter one. That's what having a firm baseline written down, and then regulators with the ability to increase it as they see fit.

UPDATE: Yglesias posted a response to EoC's critique sent from Merkley's office, that is also worth checking out as you make up your mind on this matter.

Mike Konczal is a fellow with the Roosevelt Institute and a blogger at rortybomb.wordpress.com.

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The Heirs of the Great Recession: Why Students Want Financial Reform

May 18, 2010Justin Lutz

need-job-150For America's students, graduation seems to be approaching much faster than financial reform.

need-job-150For America's students, graduation seems to be approaching much faster than financial reform.

As commencement approaches next week, the weather is calling for thunderstorms, and the imagery couldn't be more apt. What is usually supposed to be a moment of celebration and achievement has turned into a ritual laden with Schadenfreude, as the rest of the world looks on, grimacing, with talk of the recession and its heirs -- my class.

Jokes of walking off stage and into unemployment permeate any conversation about graduation. "What are you doing after college," they ask, grateful that they aren't in this place; they aren't the ones who must now pull themselves away from the institutional umbilical cord that we call (in my case) a private liberal arts college.

Sarah Lawrence College, where I attend school, is the most expensive college in this nation. Tuition and fees run around $54,000 per year. That is twice what my family of five makes in a year.

But because Sarah Lawrence is private, there is no restriction on financial aid that I can receive from the college's private endowment. This means I get about $49,000 in grants from my school each year. This takes care of the brunt of the expense, but still leaves a sizeable amount left, which is remedied by federal assistance, including Pell Grants and subsidized student loans.

There is no doubt that vying for a college education has become somewhat of a punishment. Tuition keeps increasing, aid keeps decreasing, and the job market is virtually non-existent for young people.

These problems, however, are thankfully not being completely ignored. A new report released by three youth advocacy organizations -- the United States Student Association, U. S. Public Interest Research Group, and Demos -- reveals startling facts about the financial crisis and its impact on the nation's youth, and students in particular. The study, entitled Risking Our Future Middle Class: Young Americans Need Financial Reform, points out three fundamental challenges to young Americans seeking financial reform:

- Young people (16-24 year-olds) have higher unemployment rates than any other population group.

- Programs have been cut, or tuitions increased, or both, at most of the country's public colleges and universities.

- Young Americans have high levels of indebtedness due to private student loans, credit card balances, mortgages and car loans.

America's future middle class is at risk, and with it the country's ability to compete on a world stage. We need the proposed legislation in the Senate, particularly the America's Restoring Financial Stability Act, S. 3217,  which would establish an independent Consumer Financial Protection Bureau that would protect students from unfair loan practices and the credit card manipulations that saddle us with debt.

In the bigger picture, young people need a stable economy -- at least a fair economy. We are not asking for hand outs, we are asking for a fair shot. At a time in life where we are charged with the responsibility of making ourselves into autonomous, financially-independent adults responsible for the future of this country, we deserve everything the generations before us were afforded. We need a banking system that isn't vulnerable to catastrophic collapse. We need a financial sector that doesn't suck the life out of the real economy. And we need jobs.

Every generation wants to do better than the last, but my generation has precious little chance to make this happen with out major reforms. We are being made to suffer from the mistakes of others. The boogeyman federal deficit is not what we're worried about. We are worried about the corruption and government capture that are standing in the way of reform.

As I walk across the stage, I'll keep my fingers crossed. But I won't hold my breath.

Justin Lutz is a Junior Fellow as the Roosevelt Institute.

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Restoring State Law

May 17, 2010Jeff Sovern

credit-card-fees-150Why should you care about state credit card laws? Because they often lead to high rates without representation.

credit-card-fees-150Why should you care about state credit card laws? Because they often lead to high rates without representation.

When our founding fathers fought the Revolution, one of the things they fought for was the right to have a say in the laws that governed them. And they achieved much of what they wanted: Californians can vote on California's law, New Yorkers can vote on their representatives, and so on.

But one exception is consumer loans, including credit cards. Chances are you have no voice on some of the laws applying to the loans you've taken out, such as the laws governing the interest rates you pay. Your credit card is almost certainly governed by the laws of South Dakota or Delaware, states that -- unless you live there -- you have no power in.

That's because of a little-known Supreme Court decision interpreting an even more obscure 1864 law that allows lenders to decide which state's law applies to the loans they make. And it leads to bizarre results. For example, when the Wiseman family of Arkansas wanted to buy a car from an Arkansas auto dealer, the dealer referred them to an Oklahoma lender owned by another Arkansas company. The lender wanted to charge an interest rate that would have been illegal under Arkansas law, but while that's where the car was bought, sold, and, for all practical purposes, financed, the lender was able to have the higher Oklahoma limits apply -- even though the car might never be driven in Oklahoma.

Why should you care? When lenders can pick the rules that apply to their loans, they choose the state laws which are most favorable to them, and least favorable to consumers. So credit card issuers base their operation in states like South Dakota and Delaware, which permit them to charge interest rates to citizens of New York, say, that New Yorkers consider excessive -- but the lenders don't have to care because New York can't apply its own laws to its own citizens.

Meanwhile, states that want the jobs credit card issuers bring have an incentive to allow lenders to charge high rates to attract those jobs. And if the credit card issuers charge high rates to the citizens of other states, well, why should South Dakota's officials care? The citizens of those other states don't vote in South Dakota's elections. But the bank employees living in South Dakota do.

The 1864 law that led to this was never intended to permit South Dakota to rule credit card lending throughout the country. Indeed, credit cards were still a century in the future. And so Senator Whitehouse, in Washington, has proposed to change this archaic law to permit states to apply their own usury laws to their own citizens.

Nothing in Senator Whitehouse's amendment would prevent lenders from lobbying for high usury limits. States may in fact be persuaded by those arguments. But it would prevent South Dakota from applying its usury laws to people who may never set foot in South Dakota.

Our founding fathers fought -- and some died -- so our citizens could have a voice in their laws. It's time for voters to get that voice on loan terms.

Jeff Sovern is a professor of law at St. John’s University School of Law and co-coordinator of the Consumer Law and Policy Blog.

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The Long and Short of Greed

May 17, 2010Wallace Turbeville

wall-street-150How the trader takeover of over Wall Street produced an obsession with short-term greed.

wall-street-150How the trader takeover of over Wall Street produced an obsession with short-term greed.

As a deep economic recession looms, securities held by Wall Street banks lose value. Even worse, because values cannot even be determined, the securities cannot be liquidated for needed cash and major banks fail. Investment vehicles created by the bankers to aggregate assets become insolvent. State and local governments are threatened by financial ruin. The White House authorizes mergers of major firms despite deep concerns about propriety. The Federal Government injects funds into the banks to avert a financial system collapse and is joined in the bailout by wealthy and well-known individuals. After the financial system crisis passes and the resulting recession runs its course, congressional hearings targeting bankers focus public opinion in support of major financial system legislation.

This was the Panic of 1907, not 2008. The great "trust buster," Theodore Roosevelt, personally authorized J. Pierpont Morgan's US Steel to acquire teetering steel companies to avoid their bankruptcies, consolidating US Steel's dominance of the steel industry. The government injected $35 million into the banking system -- all that was possible at the time -- but this was not enough. Morgan convened a Saturday meeting with the leading robber barons and bankers at his Manhattan home and literally locked them in his study. He released them the next morning after they signed on to a deal he brokered to save the financial system. Later, Morgan was castigated (probably deservedly) at the congressional "Pujo Hearings" for his role in creating the circumstances which led to the debacle. Morgan's associates blamed the stress of the hearings for his death a few months later. The ultimate result of the hearings was the creation of the Federal Reserve System.

Was Morgan a hero or a villain? Probably, he was both.

Historically, the leaders of Wall Street have occupied this dual role. Enormous wealth allows them advantages in the accumulation of influence and power. They have existed on the knife edge of fairness. Wall Street is usually involved when business practices lead to economic crises. Typically, millions of people are injured by events that defy their understanding. Wall Street "fat cats" are often the last culprits standing and are obvious targets of the angry public.

But at its best, Wall Street served an important function. It provided the wherewithal for growth of every industry from railroads to information technology, vastly increasing the well-being of all Americans. In times of crisis, bankers have worked to preserve economic stability. Sometimes, they have been genuine altruists, accepting the moral responsibilities that go along with their positions of wealth and power. But, altruistic or not, they understood their enormous stake in the long-term vitality of the economy. Preserving the health of the economy was simply good for business.

When I arrived at Goldman Sachs, John Weinberg headed the firm. It was a partnership of professionals then, not a publicly traded corporation, and the partners' wealth was largely invested in the firm. I saw this Marine veteran of the Pacific campaigns many mornings on the elevator with a muffin perched on a Styrofoam coffee cup, having just arrived at 85 Broad Street in his Ford (Ford was a long-time personal client). His demeanor was closer to the guy behind the counter at the deli than the titan of Wall Street that he was. But, when he spoke, he was both incisive and wise. His motto for Goldman Sachs was, "Be long term greedy, not short term greedy."

This was genuine. The firm promulgated "Our Business Principles," and the bankers bought into it. We included these in every presentation and were convinced that clients and potential clients must be persuaded that a firm with such fine principles could be trusted. Like Marines, we were convinced that we were the best of the best. But, wisely, the culture was structured to tamp down arrogance and hubris. Peer reviews became a ritual in which team play and client service were key factors. The firm installed co-heads of many groups, demanding cooperation of them. (Younger bankers predictably referred to them as "cone heads.") The practice included the heads of the firm (for instance Weinberg served with John Whitehead, who retired just after I arrived). Goldman Sachs became almost a cult.

The concept of having a stake in the long term health of American business was not unique to Goldman. At Goldman, it was just a more overt part of the culture, perhaps disguising the direct self interest involved. Since the time of J.P. Morgan, the end result was the same whether the motives were expressed as the common good or as stark self interest. What was good for a healthy and growing economy was essential both to the basic business of Wall Street and the prosperity of the people.

Trading was always part of Wall Street, the counterpoint to investment banking. Investment bankers advised clients on capital raising and mergers and acquisitions. These activities are collaborative and essentially serve the client's interest. As a result, long-term relationships and service to the client are essential to success in investment banking. In contrast, traders each have a book of long and short positions. Trader successes and failures are far more personal and immediate. The goal is not to help a client, but to strike a favorable deal with a counterparty. There were legendary struggles between bankers and traders for leadership of Wall Street firms. For the most part, however, the bankers ran the firms.

The world shifted. Trading exploded, largely fueled by information technology. It seemed that every number on earth could be divided by every other number in real time. Everything could be priced, and, once priced, could be traded. Markets were deregulated and carved into pieces, each representing a trading opportunity. The Wall Street firms, with their enormous capital resources, could dominate more and more of the price points in the American economy. Software programs could be written to access electronic trading platforms so that the enormous force of the trading houses could be brought to bear without the inefficiency of human intervention. It seemed that a business model relying on dispassionate exploitation of immediate opportunity had been perfected.

The golden rule kicked in -- "He who has the gold rules." The predominance of trading profits reversed the balance of influence in favor of the traders. Clients were no longer just clients; instead, they were counterparties to be dealt with at arm's length. In the end, the traders achieved Nirvana -- using asset pools, they were able to synthesize their own clients as sources of securities to trade. The business of trading, focused on short-term profits, became dominant on Wall Street.

The American economy has lost something in all of this. Wall Street's capital markets business serves us best when it is aligned with the long-term growth of the economy. Without this alignment, long-term stagnation is threatened. We need more Morgans and Weinbergs and fewer trade bots.

If the people perceive an offsetting benefit, they more easily tolerate the accumulation of wealth by bankers whom they may otherwise dislike and distrust. Wall Street's support of the corporate engine for growth in jobs and investment opportunities can appear to be a reasonable, if sometimes unfair, deal. A business model that focuses on profiting by exploiting price efficiencies in risk pools of pre-existing assets does not generate the same benefit. The well-documented plight of the middle class suggests that this may be more substantive, rather than just a problem of public perception. It is clear that the public tolerance of banker wealth is tenuous.

This Wall Street metamorphosis was a response to the new environment and will persist until outside forces intervene. Recalling the value of Wall Street's historic interest in long-term economic growth is not just an exercise in nostalgia for a lost era. Advanced trading practices constitute a relentlessly efficient means to deploy capital in great quantity instantaneously. If the premises behind trading strategies are flawed, however, the consequences are magnified. It is relatively easy to hire quantitative geniuses to construct algorithms and measure conditions with great precision. The decision of what to measure and the prudent use of the results is another matter. Short-term mentality is a problem. When things go wrong, and they will, this mentality assures that the damage is immediate and monumental.

The only rational choice for the economy as a whole is to curb trading practices and to align interests of Wall Street and the public. One way to align interests is to assure that bankers suffer appropriately alongside the public when the risks of their trading activities are realized. Perhaps, if trading practices are curbed and the risk of loss is shared, Wall Street's business of raising capital for long-term growth will ascend relative to trading. The alignment of interests in long-term growth between Wall Street and the public might then become a greater force.

Bankers would be wise to see that this realignment is ultimately in their interest, even if it adversely impacts immediate profits. Today's reform effort may be blunted through influence on Senators and Congressmen. But a viable contract with the American people is the only way to preserve the business over the long haul.

Be long term greedy, not short term greedy.

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

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Big Bank Usury: Warren on Whitehouse Amendment

May 17, 2010Lynn Parramore

moneylenders-150Aristotle called usury the "most hated form" of wealth-accumulation. Dante sent practitioners to the seventh circle of hell.

moneylenders-150Aristotle called usury the "most hated form" of wealth-accumulation. Dante sent practitioners to the seventh circle of hell. The Qur'an proposes that usurers are controlled by the devil's influence, and we've all heard how Jesus, that avatar of non-violence, was stirred to a round of ass-kicking when he found the money lenders in Herod's temple.

Screwing the poor through usury has been considered an abomination throughout human civilization - a disease of the body politic that sickens people morally and economically.

For two centuries, American states had the power to enforce usury laws against any lender doing business with its citizens. But in 1978, a Supreme Court case transformed the world of lending. In Marquette National Bank of Minneapolis v. First of Omaha Service Corp., the Supreme Court changed the interpretation of  the National Bank Act of 1863 so that states could no longer regulate interest rates on nationally-chartered banks. BINGO! Big banks quickly saw a Big Opportunity. They would now be able to dodge interest rate restrictions by reinventing themselves as "national banks" and hightailing it to states with weak consumer protections. A small number of states chucked interest rate caps in order to lure credit card business and related tax revenue.

Thanks to that unfortunate 1978 decision, credit card divisions of major banks are based in just a few states, while local banks struggle with unfair out-of-state competition and fight to stay afloat. Meanwhile, consumers across the country are gouged by stratospheric interest rates and fees.

An amendment submitted by Senator Whitehouse and cosponsored by Senators Cochran, Merkley, Durbin, Sanders, Levin, Burris, Franken, Brown (OH), Menendez, Leahy, Webb, Casey, Wyden, Reed, Udall (CO), and Begich aims to change all this by restoring state powers to protect their citizens with interest rate limits on lending done within the state.

Here's a breakdown of what the amendment would accomplish:

  • Restore to the states the ability to enforce interest rate caps against out-of-state lenders.
  • By Amending the Truth in Lending Act, cover all consumer lenders, no matter what their legal form, minimizing the opportunity for gaming by changing charter type.
  • Become effective twelve months after enactment - giving state legislatures time to evaluate and update usury statutes.
  • Level the playing field so that intrastate lenders like community banks, local retailers, and credit unions are no longer bound by stricter lending limits than national credit card companies.

TARP watchdog and New Deal 2.0 contributor Elizabeth Warren argues that "the loopholes that let big banks escape local laws need to be closed. She explains that there is "no good reason why large institutions should be able to headquarter in states with lax protection and then do business all over the country without following local laws. Smaller banks have to comply with tougher local rules, and the big banks should have to do the same. We need a level playing field between small, community banks and big, national banks."

Memo to Big Banks: Get ready, boys.  There's a New Sheriff in town.

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Joe Stiglitz on Derivatives Reform and Section 716

May 14, 2010Mike Konczal

SAFER has put out a letter responding to Bernanke on Section 716, which is the Section 106 fight. This is language to remove swap dealers from Federal insurance like FDIC and the Federal Reserve discount window. This language is still in the derivative bill so far, though it has come under attack recently.

SAFER has put out a letter responding to Bernanke on Section 716, which is the Section 106 fight. This is language to remove swap dealers from Federal insurance like FDIC and the Federal Reserve discount window. This language is still in the derivative bill so far, though it has come under attack recently.

And Roosevelt Institute Chief Economist and Senior Fellow Joe Stiglitz lays out his case defending Section 716 in a 5 page letter located here. You should read both because they are the strongest defenses of this language that reformers have produced to answer the last round of critiques from the administration. Here's a quote from Stiglitz's letter:

So long as those financial institutions that have access to federal assistance (or are likely to have access in the event of a crisis) can write such contracts, the government is effectively underwriting these con-tracts. The market gets distorted in two ways: first, these institutions have a competitive advantage, not based on greater efficiency, but based on more likely access to government assistance. Second, the insurance is underpriced, because it is effectively subsidized (or, when these instruments are effectively used as gambling instrument, gambling though these instruments is encouraged). Subsidies, whether explicit or implicit, distort resource allocations and contribute to a less efficient economy. There are certain instances where the government might want to encourage certain economic activities, but those should be clearly articulated and narrowly circumscribed. I see no compelling reason why the U.S. gov-ernment should be engaged in subsidizing credit default swaps or derivatives, whether they are viewed as risk management products or gambling instruments. On the contrary, to the extent that these prod-ucts have shown that they can increase societal risk, with huge costs, these have demonstrable negative externalities, and a compelling case could be made for taxing them. The amendment does not go that far. It takes a far more modest step of ending the implicit subsidy....

It is important to realize that restricting the too-big-to-fail banks from engaging in certain activities does not mean that these services will not be provided—though without the implicit subsidies, the extent to which they are used may be reduced. No evidence has been presented that there are sufficient economies of scope to offset the systemic risk to which current arrangements give rise. (And as we have noted, the fear that these activities will move to less well regulated has little merit.)...

In short, I urge you to defend the strict derivatives regulation language in the Senate Bill, including the important Section 716.

Mike Konczal is a fellow with the Roosevelt Institute and a blogger at rortybomb.wordpress.com.

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GE Capital, and an Amendment to Exempt Shadow Banks?

May 14, 2010Mike Konczal

GE Capital

People who know me well know that I am obsessed with GE Capital as being one of the key stories of the change in the American economy of the late 20th century, a story I hope to develop more 3 or 4 projects from now. GE Capital was founded in 1932 to finance dealer inventories and consumer purchases. People made things in a factory and bought things from a factory and GE Capital helped provide both a burgeoning middle class and the businesses that served it with sufficient lines of credit.

GE Capital

People who know me well know that I am obsessed with GE Capital as being one of the key stories of the change in the American economy of the late 20th century, a story I hope to develop more 3 or 4 projects from now. GE Capital was founded in 1932 to finance dealer inventories and consumer purchases. People made things in a factory and bought things from a factory and GE Capital helped provide both a burgeoning middle class and the businesses that served it with sufficient lines of credit.

Starting in the 1960s it began to provide leasing and financial services to other large Fordist-Keynesian style businesses. And then starting in the 1980s during the financial deregulatory wave it expanded rapidly into one of the world's premiere shadow banks: it was the single largest issuer of commercial paper in the United States before the crisis, with $620 billion in assets at the end of 2007.

Did you ever listen to the Giant Pool of Money epsiodes of This American Life? (You must have.) If you remember it, during the episode you meet rising subprime mortgage star Glen Pizzolorusso, who was an area sales manager at an outfit called WMC mortgage in upstate New York. He made over $1 million dollars a year handling the subprime market and spent like mad on cars, real estate, and impressing celebrities. Here's his description, from the transcript:

Glen Pizzolorusso: What is that movie? Boiler Room? That’s what it’s like...We lived mortgage. That’s all we did. This deal, that deal. How we gonna get it funded? What’s the problem with this one? That’s all everyone’s talking about...

We rolled up to Marquee at midnight with a line, 500 people deep out front. Walk right up to the door: Give me my table. Sitting next to Tara Reid and a couple of her friends...We ordered 3, 4 bottles of Cristal at $1000 per bottle. You know so you order 3 or 4 bottles of those and they’re walking through the crowd and everyone’s like: Whoa, who’s the cool guys? We were the cool guys.

He then losses it all during the crash and has to move back home. (He has since joined the Tea Party.) Now WMC sounds like a fly-by-night operation in the episode until you go and look and find out it was part of the mortgage wing of GE Capital. And sadly, GE Capital could not move back home when the capitals market collapsed; it received $50 billion dollars in bailouts from taxpayers and was the second-largest beneficiary of the FDIC debt guarantee program.

So there's a story about how GE Capital went from helping grow and finance expanding industries and expanding middle-classes to being a fly-by-night subprime dealing shadow bank. And I think that this story, about how GE Capital went from building a broad-based prosperity through financing refrigerator purchases and other middle-class non-durable goods to a story about churning home equity and piling debt on a wage-stagnating population while inequality balloons to the point where one random dude could try and impress Tara Reid with fancy champagne, this Post-Fordist transition story, is really the story of our times.

Vitters 4003 Amendment

Oh right, amendments. Sorry to get off track. So remember, one reason GE Capital could do all this was because it was a shadow bank involved in commercial banking without having to be regulated like a commercial bank. This is a regulatory arbitrage, it is unfair to regular banks and dangerous to have gigantic shadow banks subject to a liquidity run this way.

There's an amendment, Vitters 4003. It says that financial part of a multi-part firm has to "constitute 85 percent or more of the total consolidated revenues of such company" to qualify for regulation. That immediately causes two big problems: it keeps some our most notorious shadow banks outside of the regulatory umbrella, which is the whole point of doing what we are doing. If we could have done resolution on GE Capital if necessary, taxpayers wouldn't have had to step into the fire.

The other problem is that this encourages a firm like Goldman to add a 15% non-financial business line in order to avoid regulation. Which would encourage inappropriate mergers and expansion of business scope for the sole purpose of avoiding regulation. Which is even worse than just not regulating.

Keep an eye out for this shadow bank exempting amendment. If we've learned one thing from this crisis, it's that shadow banks need real regulation too.

Mike Konczal is a fellow with the Roosevelt Institute and a blogger at rortybomb.wordpress.com.

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Brokers and the Clearing Mandate: The Story Behind the Story

May 14, 2010Wallace Turbeville

money-man-200Exchange pits where people shout hysterically must be replaced with well-regulated clearing houses to avoid conflicts of interest.

It should surprise no one that behind technical provisions of the financial reform legislation lurk important real world implications.

money-man-200Exchange pits where people shout hysterically must be replaced with well-regulated clearing houses to avoid conflicts of interest.

It should surprise no one that behind technical provisions of the financial reform legislation lurk important real world implications.

We are all aware of the bill's requirement that derivatives must be cleared unless a carve-out is provided. There is also a limitation on the source of these cleared transactions. By source, I mean the venue in which the two ultimate parties (buyer/seller, long/short) to a cleared trade may be matched together. Matching venues are important to liquidity and price discovery -- the elements of transparent pricing arrived at without manipulation. The original Agriculture Committee bill limits the venues to exchanges and "Trading Facilities," a term defined in the Commodities Exchange Act. The contrary position eliminates the Trading Facility limitation.

Of course, traditional exchanges are permitted venues. In this method, a customer seeks a derivative from its clearing institution (technically a Futures Commission Merchant, or"FCM"). Historically, the FCM takes the request to an open outcry pit at an exchange where people in strangely colored jackets behave hysterically. The FCM representative tries to find other FCM representatives who have a customer seeking the other side of the same transaction. In fact, both FCMs transact with the clearinghouse attached to or embedded in the exchange. Clearing eliminates direct credit exposure to the ultimate counterparty so that the basic deal is anonymous.

In the pits, there are opportunities to behave badly and profit from market intelligence. These are, of course, against regulations, but it would be naïve to believe that deterrence is 100% effective.

It should be obvious that people screaming in pits can be replaced by electronic systems. Nowadays, much of the exchange-based matching function is provided by electronic systems. One benefit is the elimination of the potential for gaming the system in the pits.

Trading Facilities, the other permitted matching venues for cleared transactions in the original bill, are similar to exchanges. They include electronic systems through which off-exchange buyers and sellers are matched. It is permissible for Trading Facilities to incorporate algorithms used to adjust bids and offers that do not match exactly. Users of the systems are aware of these algorithms and consent to the results. In the context of the pending legislation, the trade data for the buyer and seller would be transmitted to their respective FCMs for clearing. The critical point is that once the match is made, there is a live contract. The transaction is consummated without human intervention in an anonymous environment with transparent rules and little or no opportunity for gaming the matching process.

The change proposed to the original bill replaces "trading facilities" with "facilities." Effectively, this change permits individual brokers (people, rather than electronic systems) to use telephones, electronic bulletin boards and instant messaging to match buyers and sellers of derivatives and then forward the transactions to the clearing process. Brokers are permitted to participate in the class of transactions which are mandated for clearing. The difference is that human intervention in the basic pricing transaction is allowed. Anonymity is compromised since the broker knows the parties involved. Opportunities for intervention of influences extraneous to the basic deal are introduced. For instance, a broker might favor a customer who provides greater business flow, perhaps to the detriment of the other side to the trade who is also a customer. While this type of behavior is not permitted, it is obviously difficult to police.

Today, brokers often match derivatives in which the buyer and seller elect to clear rather than to transact bi-laterally. The clearing decision is often part of the matching process. For instance, the parties might prefer to transact bi-laterally, but one of them may have reached limits on the amount of credit exposure available for transactions with the other side. Clearing allows the consummation of the deal, even though it was not the preferred method.

Brokers do serve a purpose in the marketplace. One reason a trader may use a broker is referred to as "relationship." This can mean several things. A trader may transact through a broker to give him business so that the broker will be available and attentive when he is really needed to find a counterpart sometime in the future. A broker may also be used because of friendship or other social reasons, such as entertainment.

Brokers may also be necessary to find a match. There may be insufficient liquidity on electronic matching systems to get a transaction done. Electronic matching is passive. It requires both sides to post their desire to transact. Voice brokerage is active. The broker can initiate the proposal to transact with a potential counterparty. The most obvious legitimate reason to use a broker is to transact a derivative for which active efforts to match are required. These are derivatives for which the market is inactive, i.e., illiquid.

Is the access to liquidity a good trade off for the opaqueness of a brokered market? This is a tough question, but not just because the relative values of liquidity and opaqueness are imprecise. Fundamentally, the very premise of the question defies reason.

Remember, we are discussing broker matching of trades for which clearing is mandated. All of this raises a fundamental question: if a transaction is so illiquid that a broker is needed to actively solicit for counterparties, should it be cleared in the first place? The basic premise for clearing is that items cleared must be liquid. The systemic integrity of a clearinghouse is based upon the ability to predict reasonably the cost of replacing transactions lost in a default. Their statistics depend on a continuous, liquid marketplace. Without this, historic price data is not a good basis for estimating the cost of a forced transaction, especially in the stressed environment of a default.

Yet the industry and the lawmakers perceive an overlap between the clearing mandate and legitimate uses of voice brokers. This relentlessly leads to a conclusion that the new environment will involve increased systemic risk as clearing of illiquid transactions will increase.

This phenomenon exists already. Increased trading activity has consumed available credit extension capacity restricting the ability to consummate bi-lateral trades. Today, clearinghouses compete ferociously with one another for volume. New transactions have been added repeatedly, even though their liquidity is doubtful.

Passage of the financial reform requires a new and innovative examination of clearing itself. Sticking to the old ways of doing business runs the risk of another systemic threat, this time to the clearing systems. The threat is increased by mandated clearing. There are ways to address this problem. In short, limiting clearing system exposures beyond the statistically determined levels of collateral for certain transactions and techniques for distributing the excess risk back to the traders make sense.

Passage of the legislation is a good thing. Failure to follow up with innovative implementation could turn a good thing bad.

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

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