Bread and Derivatives

Jun 24, 2010Wallace Turbeville

breadGoldman's control of market structure might just starve us, strand us, and leave us in the dark. Literally.

breadGoldman's control of market structure might just starve us, strand us, and leave us in the dark. Literally.

In 2008, before the financial system almost melted down and threatened an economic collapse of biblical proportions, some very odd events occurred in the market for commodities derivatives.  It is now clear that financial institutions and investors already understood that the mortgage market was teetering and that severe problems for the financial firms were on the horizon.  Stress was building, but how did this relate to the commodities markets?  We still do not know for certain, but we do know that it coincided with peak investment levels of $317 billion in several investment vehicles known as commodity index funds.

In 1991, Goldman Sachs invented the commodity index fund.  While several other firms have replicated the fund, Goldman has maintained a 60-75% market share.

A key factor in the success of commodity index funds was an exemption granted by the CFTC from limits on speculative positions. It allowed the fund holdings to grow enormously.  Whatever the rationale was at that time, the conditions have changed and history suggests that the decision was unwise.

Goldman would take in funds from clients and invest the proceeds in futures contracts, a portfolio of energy, agricultural, minerals and financial contracts. It would be a sponsor and manager of the structure, not a principal. Futures contracts fluctuate based on the price of a commodity at a specified date in the future. For example, a barrel of oil to be delivered in August might be worth $70 to both a buyer and a seller as of today. The futures contract between a notional buyer and seller is essentially a financial instrument which continuously tracks that price each day until August arrives and the final price is known. It is not about actual oil, but rather the price of actual oil on a future date.  A futures contract is the functional equivalent of a swap and is a derivative of the cash market for the given commodity.

The idea of the fund was not to trade short and long positions or hedge physical prices on delivery of the commodity. The fund ignored market views and only bought one side - the side on which value of the futures contract increased as the expected delivery price increased.  The fund sponsor rolled over each contract into a new contract before the notional delivery date occurred.  By rolling over the contracts, the fund became infinite, a rolling investment in an index of prices for commodities that never had an end date.

Goldman and other banks made plenty of money from fees and float (the cash paid by investors was mostly held by the banks as long as everything worked well).  A side benefit was the huge increase in the volatility of commodities markets.  By flooding the markets with one sided contracts (especially on roll over dates), price movements became more severe.  Absolute commodities prices trended relentlessly higher and higher.

Volatility is essential to profits for the trading operations of the banks. Traders make money from price movements; stable prices mean low potential for trading profit. The logic is that commodities index funds lead to volatility which leads to trading profits for the fund sponsors. Goldman and other banks discovered that the commodities index fund operation, originally designed as a product for clients interested in investing in commodities markets, changed the marketplace and allowed them to trade for their own accounts far more profitably.

In recent years, most fund clients were not directly interested in the underlying commodities.  In a 2005 paper by Gary Gorton and Geert Rouwenhorst, it was demonstrated that returns on commodities are inversely related to stock market returns.  This relationship is especially strong in early stages of a recession and when share prices are lowest.  If you believed that equity prices were going to go down (or if you wanted to hedge exposure to the stock market), you could make money by buying the index. By 2007/2008, as investors became concerned about returns on their equities investments, the commodities index funds grew rapidly as a hedge against a falling stock market and futures prices rose.

Over time, futures prices should converge to the actual delivery price for the commodity at the delivery date. The futures price is no more than the expected price of the commodity on delivery. On that date, the value of the futures contract and the value of the actual commodity are the same.

In 2008, this relationship became unhinged, particularly in agricultural markets. This coincided with a shift of fund assets from energy to agricultural futures. Remember that the funds were designed to be perpetual and the roll over of contracts made delivery dates irrelevant.  Because the holders of so many futures contracts did not care about actual delivery prices, the futures markets lost their relationships with the physical markets which are centered on delivery dates.  Physical delivery (or "spot") prices increased as if futures were driving spot prices rather than the other way around. But they could not keep pace with the perpetual index prices.

To many observers, the practical significance was a massive increase in the price of bread and fuel oil and many other products for reasons that defied the simple logic of supply and demand. (See Fredrick Kaufman's "The Food Bubble" in Harper's.) Consumers worldwide paid a heavy price. Some believe that the price spikes led directly to food shortages in the developing world.

For corporate producers and consumers (farmers, airlines etc.), the usefulness of futures contracts was lost because these contracts were so volatile and no longer usefully hedged real prices.  Hedging only works if the futures converge to spot prices.

A byproduct of the financial crash was more normal price relationships. But there is no doubt that the banks prospered from owning a market structures that indirectly served their trading activities. The underlying structure survives and CFTC regulation of position sizes is under discussion.

The CFTC believes the funds at a minimum contributed to price increases and volatility.  It is considering regulation of position sizes of funds.  The CFTC conclusion has been disputed, however. One academic paper by Scott Irwin and Dwight Sanders, professors at the University of Illinois at Urbana-Champaign, suggests that the evidence for pricing pressure is unproved.

Nonetheless, the coincidence of events is troubling; so troubling that the Irwin/Sanders paper seems inadequate. From the time of the discovery of the relationship between the commodity index funds and the stock market

  • Investment in the funds more than doubled;
  • Commodities prices spiked, most significantly agricultural products and oil (wheat prices, for instance, tripled);
  • Volatility in commodities markets increased;
  • For a period, futures price convergence with spot markets ceased working in some markets; and
  • Importation of food by developing countries declined markedly and hunger increased.

The problem is that the markets are not simply abstract environments for esoteric investments.  They are the price and supply mechanisms for food, energy, money and many other real world items. They affect real people when they put food on the table, fill there cars with gasoline, turn on the lights and pay their mortgage and credit card bills each month. To the extent the large financial institutions continue to influence and control these markets, the promise of financial reform is diminished. Limitations on speculative positions facilitated by vehicles such as commodities index funds is a matter of moral as well as financial necessity.

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

ND20 ALERT: Join us in NY for fresh ideas, July 16-18! Guild Hall, in collaboration with the Roosevelt Institute, will gather thought leaders in the arts, the economy, and the media in East Hampton for a can't-miss symposium featuring George Soros, Van Jones, plus ND20 contributors Elizabeth Warren, Rob Johnson, Jeff Madrick, Editor Lynn Parramore, and more. RSVP today - seats are limited.

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ND20 Alert: Tom Ferguson joins "On Point" Tomorrow, 10am ET

Jun 23, 2010

alert-button-150Senior Fellow Tom Ferguson will join NPR's On Point radio show tomorrow morn along with Paul Singer of Roll Call and Nick Allard, head of Patton Boggs' lobbying wing.

alert-button-150Senior Fellow Tom Ferguson will join NPR's On Point radio show tomorrow morn along with Paul Singer of Roll Call and Nick Allard, head of Patton Boggs' lobbying wing. Focus will be on finreg + lobbying and the culture of Washington, campaign finance and the NRA exemption, BP, and Obama's overhaul efforts. Tune in online or on the radio.

Also check out Ferguson's white paper on the midterm elections and recent New Deal 2.0 posts:

MIDTERM STORM BREWING? Ferguson and Chen Reveal Real Story of Massachusetts Election Upset

And these:

Ask Holder to Be Bolder: Resolving the Mysteries of AIG

New Agenda for America: Mirror, Mirror on the Wall...

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Overdraft, Financial Access and Consumer's Experiences

Jun 23, 2010Mike Konczal

Stephen Spruiell did not like my previous characterization of his opinions on consumer finance, nor does he like the idea of consumer protection (my numbering):

Stephen Spruiell did not like my previous characterization of his opinions on consumer finance, nor does he like the idea of consumer protection (my numbering):

[1] Is Konczal really trying to argue that poor people aren't capable of understanding the connection between overdrawing their checking accounts and overdraft fees? Somehow, liberal condescension is still capable of surprising me....

[2] I like the way pietistic financial "reformers" such as Mike Konczal attribute sadistic motives to their opponents ("smacking around poor people") while pushing "reforms" that will in all likelihood lead to an increase in loansharking (poor people actually getting smacked around). Kevin Drum is right about this if nothing else — overdraft fees are a form of short-term credit offered at very high interest rates, like payday loans. But there is a persuasive case to be made that such forms of credit are actually welfare-enhancing. Liberal scolds look at the high annualized rates and shriek, but they're not thinking of the unintended consequences: What would happen if these forms of lending were restricted? Would poor people suddenly stop needing credit? Who would step in to fill that gap? Credit-card debt is fully dischargeable in bankruptcy, unlike debt owed to the Bank of Vinnie and Frank....

[3] You know, there's another way to opt-out of this service: Don't overdraw your account.

In response.

[1] Spruiell argued that people who pay overdraft fees are "inept." He seems to stick by this in his post, so let's discuss this. I provided evidence from FDIC that says that a large amount of the poorest bank consumers, the people most likely to pay fees, and the people most likely to pay the most fees, have very little money in the bank. 60% have less than $100 on average. Is this "inept"? It makes perfect sense for a person to want to pay a premium upfront to not get hit on the back end with a large amount of fees for overdraft, to want to opt-out of this feature.

In [3], he says you can already opt-out by not overdrawing the account. I think a problem is that Spruiell views the banking relationship as an independent thing floating out there, that people can use or not use responsibly, like a car or a gun. The reality is that charging fees on their unsuspecting clients is a major profit source for these banks, and they are actively and rationally trying to maximize this. How else can you explain double cycle billing for credit cards, or for this issue, the shuffling of charges banks used to do to maximize overdraft? The bank is not neutral, but an opponent for clients much of the time. So by "opt-ing out", he means both watch your finances and be smarter and more nimble than the financial sector. Good luck, unless you are in a position to sit $1,000 in a checking account and pay off your credit card monthly without stress. I don't think people are stupid, and I'm not condescending to them, I just think in reality people are not perfect calculators, especially when the other side is "nudging" you to pay fees.

In most circumstances this is fine; if people lose money by ineptly playing darts or basketball after putting money on the game, that's their problem. But given that access to basic banking is a prerequisite for functioning in the normal economy, this should worry us.

Aside: with technology and without regulation, the tendency toward the sophisticated quiet bleed of consumers and finance will increase. Kevin Drum wondered about the future of privacy in purchases recently, and various people told him to await the superfuture that is coming. I forgot to mention to him the most obvious thing I remember in this vein: the FTC complaint (settled) that CompuCredit was changing terms on credit cards depending on where you made purchases, with one nice example being increasing your interest rate for paying for a marriage counselor with your credit card, as divorce is a risk factor for not paying your bills. Classy.

The card networks were trying to get SKU data, and I'm not sure how that battle is currently going. But if so, without regulation, you could get your rates jacked for, say, purchasing music or books associated with depression, as depression is correlated with poor bill payment. Watch out emo kids! It's almost like an unregulated financial sector functions as some sort of crazy 18th century theoretical prison here, where it is always watching your behavior from a central, opaque location, and you are never quite certain what will make it jump and attack.

[2] As for me pushing people into the mob and loan sharks, is there good evidence of that happening? I'd be curious as to the evidence Spruiell would muster, but all I know of this are my own experiences, as well as this study by Harvard Law professor Angela K. Littwin in Comparing Credit Cards: An Empirical Examination of Borrowing Preferences Among Low-Income Consumers:

One of the strongest arguments against regulating credit cards is the substitution hypothesis, which states that if a restriction on credit cards decreases access, borrowers will respond by using other, less desirable forms of credit. For lowincome consumers, the argument is more powerful still, because their other options are high-cost lenders such as pawn shops and rent-to-own stores. But the substitution hypothesis has been more frequently assumed than investigated, and the empirical research that has taken place does not support the theory as strongly as has been supposed. This Article presents original data from a study of low-income women. The findings suggest that lenders such as pawn shops and rent-to-own stores may function as complements more than substitutes. More critically, low-income borrowers may experience credit cards as no more desirable than these other borrowing types. In addition, the research uncovered another form of credit that low-income families routinely use and participants evaluated favorably, but that is never discussed in literature. Both results indicate a need to develop a more nuanced formulation of the hypothesis that better predicts the consequences of credit card regulation...

Middleclass bias and traditional economic methodologies have meant that all regulation-driven substitution away from credit cards has been assumed to be harmful. But the current study suggests that credit cards are actually among low-income consumers’ least-preferred sources of credit, meaning that there is no “worse” alternative to which they would turn if credit card access were reduced.

Spending isn't necessarily going to be exogenous here, so the idea that the poor will go to loan sharks needs more evidence (and I'd be willing to read it, my mind isn't made up here). People are more likely to go to friends and family than loan sharks, the study finds. And it's important to remember that the poor also find the current credit and financial access they have predatory, just another type of pawn shop and rent-to-own. Nicer suits on the people, perhaps.

Mike Konczal is a fellow with the Roosevelt Institute. You can find him on twitter here.

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Elizabeth Warren Tackles Tim Geithner, FinReg and Car Dealers in 3 Clips

Jun 23, 2010

New Deal 2.0 contributor Elizabeth Warren has appeared on camera three times in the past 24 hours -- and she still has a lot of fight left in her. First Warren took on Tim Geithner, repeatedly asking him for his "metric for success" in the HAMP program, meant to help families avoid foreclosure. "Is it 120,000 families saved over 15 months at a time when 186,00 are posted for new defaults and foreclosures every month? Is that a successful program?" she asked. Tim didn't have a response.

New Deal 2.0 contributor Elizabeth Warren has appeared on camera three times in the past 24 hours -- and she still has a lot of fight left in her. First Warren took on Tim Geithner, repeatedly asking him for his "metric for success" in the HAMP program, meant to help families avoid foreclosure. "Is it 120,000 families saved over 15 months at a time when 186,00 are posted for new defaults and foreclosures every month? Is that a successful program?" she asked. Tim didn't have a response.

Next in her crosshairs was financial reform. The CFPA is a strong agency, she says -- as long as it doesn't get chipped away at in conference committee. But as for the rest of the provisions, it's unclear "whether they push hard enough, whether we get enough done" to "feel like we've wound real risk out of the system." We haven't dealt with concentration, she says, nor have we dealt with derivatives, so we "continue to live with that risk."

And last but not least on her list were car dealers, who have been lobbying to be excepted from the new CFPA. "A car loan is the second biggest loan that most families will ever have in their lives," she told the Nightly News. So tell us again why they should be exempt?


Visit msnbc.com for breaking news, world news, and news about the economy

And also check out her New Deal 2.0 posts:

The Fight for Vital Consumer Protections

Feminomics: Women and Bankruptcy

Real Change: Turning up the heat on non-bank lenders

New Agenda for America: The Great Lesson”

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BP Lesson: Big Government Myths Are Undermining America's Future

Jun 23, 2010Jeff Madrick

picture-2Government does the most damage when it fails to act. ND20 ALERT: Jeff Madrick will be addressing this topic at the upcoming Hamptons Institute/Roosevelt Institute symposium July 16 - 18.

picture-2Government does the most damage when it fails to act. ND20 ALERT: Jeff Madrick will be addressing this topic at the upcoming Hamptons Institute/Roosevelt Institute symposium July 16 - 18. RSVP today - seats are limited.

We have had two towering examples of the failure of unregulated private enterprise before us, but still the push-back against government intervention continues. The oil rig explosion in the Gulf and the collapse of credit around the world in 2008 have demonstrated more than at any time since the Great Depression the importance of bold, intelligent government. Yet we are treated time and again to all the clichés about the merits of unrestrained private enterprise and the lurking danger of government. The Glenn Beck caricature is one thing. But there is plenty of push-back from old-new Democrats, Third Way advocates, and, of course both moderate and right wing Republicans.

The recent record of unregulated private enterprise is deeply disturbing. Apparently, the more you are paid by your corporation, the less of its workings you are supposed to know. Before Congress, Tony Hayward pleaded ignorance about BP's safety measures or even the current strategy to contain the tragic damage. He makes $6 million or so a year.

In May, Bob Rubin, who made $15 million a year, eagerly admitted to the Angelides Congressional investigatory committee that he did not know Citigroup (where he was effectively running things) had $43 billion of mostly-toxic collateralized debt obligations on its books until the fall of 2007, when the firm was forced to take tens of billions in losses. His boss, Chuck Prince, who took over as CEO of Citigroup following Sandy Weill (at a time when the firm was the largest banking operation in the world), said he did not realize they would lose so much money. He left in 2007 with about $80 million, pleading ignorance of the complexities of securitization and therefore any responsibility for it, or so it seemed. Stan O'Neal, the bright investment banker who tried to turn Merrill Lynch into a hip, super-profitable investment bank by issuing more collateralized debt obligations than anyone else, said he had no idea the losses were that high. He left with $160 million.

When Robert Reich suggested that the federal government intercede more in the matter of the oil fiasco on a recent Sunday talk show, columnist George Will reflexively said we don't need any more government run-companies. Has he seen the news?

Of course, there are many who blame Fannie Mae and Freddie Mac for the credit fiasco, but this is nonsense. They had a part, but the private sector sold the majority of the subprimes mortgages by far, and basically all of the highly dubious, if not outright fraudulent, collateralized debt obligations -- without government guarantees. More to the point, Washington, in thrall to the free market ideologues, had long ago turned Fannie and Freddie into private, profit-making corporations. They paid their CEOs millions-in some case of tens of millions. Surely if they were private, they'd be run more efficiently, went the thinking.

Markets can work if prices are transparent and conflicts of interest minimal. But even then, especially in financial markets, regulation is needed to mitigate herd behavior, outright self-interested fraud and the illegal circumvention of rules.

Why are these concepts so hard to grasp? The anti-regulation political regime first gained momentum under Jimmy Carter (Richard Nixon also did some deregulating, but in fact more regulating). It went full speed ahead with Ronald Reagan, who gutted the National Transportation Safety Board, the Food Safety and Inspection Service, the Consumer Product Safety Commission, and the Occupational Safety and Health Review Commission. Anti-trust bashing was all the rage under Reagan. Labor laws were poorly enforced and fines for infringements were minimal. He cut the staff of the Federal Trade Commission and the anti-trust division of the Justice Department by half. George W. Bush was absolutely brilliant at putting people in charge of the regulatory agencies who wanted to defang and incapacitate them.

Yet supposedly reasonable people still believe that somehow America was saved by the government push-back in the 1980s and 1990s. I read this in middle of the road analyses all the time. Bill Clinton's announcement that it was the end of big government defined the new Democratic Party, and still represents good common sense to many. In fact, government never got substantially smaller-under Reagan or even Clinton. And, above all, America was not saved. There was thankfully a technology revolution in the 1990s, but much of the prosperity was stimulated by wildly overpriced stocks and Alan Greenspan's crisis-induced interest rates cuts. The Asian financial crisis and Russia's default had as much to do with Greenspan's supposed prescient interest rate reductions than faith in the New Economy.

It should be clear to all readers that there is no serious evidence that so-called big government reduces growth or GDP per person. Some economists make the claim when comparing, say, European nations to the U.S. But the statistical work never holds up under close examination. Others show just the opposite. If the issue was as settled as so many claim, there would be no ambiguity about the evidence. In fact, the evidence shows no relationship at all between the size of government and slow growth.

When the FBI says there is an epidemic in fraudulent mortgages loans and no one in Washington does anything about it-which is what happened in 2004-this nation is no longer being governed the way it once was. Democracy is failing.

Theories were developed in these years, led by economists like Milton Friedman, Ronald Coase and James Buchanan that government was basically self-interested business at work, only far more inefficient. Coupled with anger and frustration in the 1970s, Americans turned against government. The tax revolts, resisted as late as 1973, took hold by the late 1970s.

Such ideology is undermining America's future. The reflexive belief that government is bad on the face of it, and business good, is not supported by history or theory. After the last two years, if government is not recognized as a premier agent of change and the main coordinating institution of the economy, the creator and enforcer of laws and property rights, the principal guardian against abuse and protector of social equity, it will be one of the landmark failures of governance in our history. A great democracy is being usurped. Pundits write with no sense of history, theory or skepticism. Washington remains subject to wealthy influence. Two hundred years ago, liberal politics once fought an autocratic state. Now liberal politics must fight a powerful private sector. America needs balance, not ideology. The public discourse is now simply wacky. Balance, not ideology.

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

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The Case for Regulating Interchange and Banking Accounts

Jun 21, 2010Mike Konczal

Matt Yglesias writes a good post I'd normally agree with:

Matt Yglesias writes a good post I'd normally agree with:

Regulate business to prevent negative environmental externalities, sure. Basic safety, okay. But the idea that what we need is for a bunch of people to get together and say that it would be better to ban this and that and the other capitalist act between consenting adults just strikes me as the wrong way of going about things. Purely economic regulation of this sort doesn’t have a compelling track record, runs into all kinds of Hayek-esque knowledge problems, and is basically an open invitation down the road for regulatory capture and the use of rules to prevent the emergence of competition. Count me out.

Kevin Drum responds. I'm going to respond as well.

Meta Interchange

The first meta-question is whether or not it is socially desirable to have a payment system trade "at par." If I write you a check for $100 you can cash it for $100. This is not a state of nature event; it's a result of the Federal Reserve's action in taking on some of the clearing risk. Do we need a payment system of debit where companies with shareholders gets to take a 2% cut of debit transactions? This is a transaction of moving my money from point A to point B, not lending credit through a credit card's revolver line. If you are uncomfortable with this, you may also be uncomfortable with the way the clearing mechanisms on checking accounts work. I would like to see this cut as narrow as possible, to keep a financial sector that allows us to transact in the real economy, not the other way around.

The second meta-question is whether or not there is something unhealthy about a payment system that blurs the line, on purpose, between transactions and revolving lines of credit. The system is set-up to encourage you to use credit as much as possible, and then pay that credit off later. This is not an accident. The common phrase among credit card company people is that people are "sloppy payers", and these sloppy payments function as a major profit center for businesses. This system also transfer money upwards in a regressive, tax-free manner and distorts prices so that shareholders of financial companies can get a cut.

My regulatory impulse kicks in for a couple of reasons. One is that interchange rates are the highest in the developed world and increasing. Rates have been jacked in the past year and we've seen no slack in demand for the services.

No Fix in Sight

The two obvious things I would expect to combat this don't look likely to move. Competition is actually backwards. Since the credit market is so crowded, and people already have so many cards, competition works by getting more rewards into a card to get people to buy them. Those rewards come from merchants. So competition among interchange will drive up the rate.

Technology breakthroughs, the other things to break up oligarchies, also don't look likely. I can't find it now, but recently there was an article about the future of consumer finances online (maybe in Wired?). A lot of revolutionary stuff could be coming, but none of it looks to be able to cut the legs out from the interchange system. I talk a lot to the online tech finance people, and try to keep up on what is happening in the medium term, and I don't see much that is moving in order to put competitive pressure on the credit card model. I think that plastic will be the future in the 21st century, and there's a clear structure of who sets these prices.

Merchant Restraints

There's a lot of talk about markets, but markets are abstractions that form over the ability to contract. And right now the "merchant restraints" in the contract that merchants sign with the financial industry are distorted. The contracts they sign prevents them from distinguishing between debit and credit, and it is not surprising that the market that forms over this is also distorted.

And this is the payment system. If it was a random consumer good, I would care much less about cross-subsidies and squeezing. If people who drink their coffee black subsidize cream and sugar coffee drinkers, whatever. But this is the very mechanism of which our economy runs - the way in which we trade goods and services. If distortions goes to the core of the economy, it doesn't surprise me that we have a lot of bad scenarios much further downstream.

And my preferred solution to this problem is simple and elegant: let merchants give discounts for debit. Many won't. I offer to type my pin in, and many places don't care if they are busy and encourage me to just sign. Merchants are in the best place to determine how much they value speed, convenience and extra volume, to the extent there is value in these things for signature credit, versus the discount of debit. And give the Federal Reserve the ability to monitor and regulation interchange fees for debit, much in the sense they do a similar function for our checking accounts (though this bill doesn't go as far as the Fed deal with checking). Taxing people's rewards is the other way to go, but I imagine that would be much more of a headache.

Overcharge

I was at a book event for Gary Rivlin's Broke USA, which I'm reading and is fantastic so far, and I was talking with several other financial style writers (I got to meet Mark Gimein, of the walking away posts I quote a lot), and we were discussing payday lending.

My general opinion is that I am for payday lending in theory but against it in practice. A short-term unsecured loan to someone functionally off the real economy's grid is going to be an unpleasant loan. What I don't like is the "sweat box" model, the type of lending that is equivalent of throwing a net onto someone already at risk and when they can cut their way out they are done. You see this with the requirement in many payday lenders to have to pay off the entire loan in order to end it; you see this with toy models we've built at this blog of things like fix pay with credit cards, where if you can charge usury rates, your goal is no longer to get paid off but to not get paid off right away. Not necessarily wanting to get paid off right away creates all kinds of incentive and informational problems.

My ideal solution is public option style "vanilla products", with a relatively deregulated market floating around that. Require that a certain type of product that is non-explosive be sold by financial dealers, and then whatever else people want to sell go have fun. This is a model that works for auto insurance companies, by the way. The fact that it is clear how the auto insurance model works isn't a state of nature or natural market outcome - the government is involved with that.

Because if you dig down into some microeconomic models with a little bit of behavior theory, you can see why this gets broken. I spend some time thinking about what it means for markets to have "informed" and "uninformed" participants. The neoclassical story is that the most informed drive the market into equilibrium that is best for all, and that the uniformed piggy-back, through consumer welfare, onto their information. Markets as information aggregators.

But maybe it doesn't work that way all the time. Maybe it works so that the informed can subsidize themselves off the wealth of the uninformed, and that firms will actively look to exploit this. I want to draw everyone’s attention to a paper by Gabaix and Laibson, “Shrouded Attributes and Information Suppression in Competitive Markets” (MR has a copy of a layman’s overview). If you speak Micro, it’s just a fascinating paper about how markets clear with naive investors and fees (one of my favorite papers).

It’s a look at markets where there are low cost, high hidden fee firms, and how competition from medium cost, no fee firms will lose. What’s interesting about this is it is generalizable to a wide variety of favorable market conditions (zero-cost advertising, for instance). And luring sophisticated consumers away won’t work as they are cross-subsidized by the naive consumers paying fees. Another way of saying this is that it is very difficult to break this equilibrium once it is in place, and it's especially difficult to break this if the person who is "uninformed" is really just "broke." And I think the evidence is clear that this cross-subsidy, persistent bleeding equilibrium of banking is what our current consumer financial system has ended up in, and I don't think we'll break out of it anytime soon.

Participation

And I think Steve Waldman had it best back during the vanilla option debates:

Consumers know they are at a disadvantage when transacting with banks, and do not believe that reputational constraints or internal controls offer sufficient guarantee of fair-dealing. Status quo financial services should be a classic "lemons" problem, a no-trade equilibrium. Unfortunately, those models of no-trade equilibria don't take into account that people sometimes really need the products they cannot intelligently buy, and so tolerate large rent extractions if they must in order to transact.

The price of assuring that one is not taken advantage of by financial service providers is not participating in the modern economy. You cannot have a job, because payments are by check or direct deposit. You cannot buy a home or a car, because for the vast majority, those purchases require financing. Try travelling with only cash for plane tickets, hotel rooms, and car rentals. People will "voluntarily" participate in markets rigged against them for the privilege of being normal. And we do, every day...

Rather than being anti-market, vanilla financial products would help correct very clear market failures that arise from imperfect information and high search costs. It is the status quo that is anti-market.

If people do stupid things with consumer products it is, in general, a their problem. But to see people exploited on what is a pre-condition to full participation in the modern economy should make us believe they are exploited through and through. If it's part of a liberal vision that people need to have their basic ability to participate in the economy in order to pursue wealth, contracts and happiness, and access to the financial space is part of this basic ability (and it is), it should be offensive that people can't get a checking account without being bled dry.

That said, I'm not sure what the solution is. A government-public-option postal savings account mechanism strikes me as much better than trying to micro-manage these firms. I wonder if just letting Wal-mart become a bank would solve this problem. Micro-managing is difficult if only because those on the other side are smart and, frankly, quite willing to exploit. They'll always be one step ahead, so a pure regulation response is difficult to do. But this is what motivates my case here.

Mike Konczal is a fellow with the Roosevelt Institute. You can follow him on twitter here.

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Where Have All the Investigators Gone?

Jun 21, 2010Marshall Auerback

investigate-150As I said before, we're quick to do criminal investigations on BP, but curiously resistant to do the same for Wall Street. Preet Bharara, the U.S.

investigate-150As I said before, we're quick to do criminal investigations on BP, but curiously resistant to do the same for Wall Street. Preet Bharara, the U.S. attorney in Manhattan, who is said by the Washington Post to be overseeing some of the highest-priority investigations, claims: "We have never been working harder, have never put so many resources into investigating and prosecuting corporate fraud in this office. . . . If there is anything to get to the bottom of, we will."

Really? Has anybody within Justice asked why hundreds of lenders, many thousands of loan brokers, and enough appraisers contemporaneously worked together to make millions of fraudulent loans? Or examined why Wall Street and others were willing to buy millions of fraudulent loans at par? Both of these critical questions can be expanded to include the question of why the auditors and rating agencies were willing to aid and abet these endemic frauds. These questions become all the more astounding because this overwhelmingly took place after the FBI's 2004 warning (which adopted the "epidemic" language of Inman News' 2003 warning) of an "epidemic" of mortgage fraud that would cause a "crisis" if it were not stopped and the industry's widespread adoption of the term "liar's loans" to describe what was rapidly becoming the industry norm in early 2007.

When you have a regulatory environment which appears to adopt as its mantra, "Don't ask, don't tell," it makes it easier for financial fraud to metastasize aggressively. Gresham's law, which says "Bad money drives out good," becomes operative. Standards dissipate and financial fragility intensifies. As Bill Black noted to me in a recent private email correspondence,

We used to have rules requiring (1) that lenders take certain minimum steps to underwrite before making a loan and (2) that they contemporaneously document their compliance with those steps and retain records documenting the steps they took. Violating a rule is typically not a crime. But control frauds faced a terrible dilemma under our underwriting rules. If they documented (1) that they knew they were making a terrible loan before they made it or (2) that they did not take even the minimum underwriting steps that were mandatory they made it easy for us (the regulators) to take enforcement action against them or place them in receivership. As a result, they typically lied. That is a crime, and a crime that is easier to prove. It is a crime that jurors understand and rightly believe indicates not only the requisite criminal intent, but also a pattern of covering up their fraudulent loans. The regulatory underwriting requirement also made it far easier to work with honest (but deadbeat) borrowers as witnesses. They could testify that they disclosed honestly their poor income, credit history, etc. to the lender and then review the false records that the lender placed in the file. It also made it easier to "flip" dishonest borrowers who would testify that the lender worked with them to create a dishonest loan application. Having these cooperative witnesses is very useful to prosecutors.

How about hiring an additional 1,000 people to the FBI for the purposes of examining financial fraud? As Black has rightly argued, we have fewer law enforcement resources devoted to fraud than we did during the S&L crisis. Yes, 9/11 understandably diverted manpower, but why have these officers never been replaced? In an environment of double-digit unemployment, it's not as if there's a huge bidding war between the government and the private sector for employed labor!

When you do not regulate a financial industry effectively you, de facto, decriminalize accounting control fraud in that industry. For more, read how cases brought against Wall Street are lagging in the Washington Post.

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

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The So-Called Death of "Free" Checking

Jun 18, 2010Mike Konczal

A lot of people are talking about the death of so-called "free" checking that could be in the works at Bank of America. Here's Kevin Drum and Felix Salmon writing about this. Felix also mentions interchange and credit unions in his post.

A lot of people are talking about the death of so-called "free" checking that could be in the works at Bank of America. Here's Kevin Drum and Felix Salmon writing about this. Felix also mentions interchange and credit unions in his post.

A few things, and then two comments I want to get at. First off, and Adam Levitin beat me to it, is that you almost certainly don't have free checking. What you have is a monthly fee that is waived if you do certain things. See BoA here. Unless you are a student at that page, you don't get free checking, you get a monthly fee waived if you direct deposit and/or hold a minimum balance. There was the story that was going around in February about how the recently unemployed were realizing that their "free" checking had been turned off because they no longer had any income to direct deposit. Which is to say, it was free until it wasn't.

Spruiell

When I was writing about Tim Lee's thoughts on interchange, I was going to joke that maybe he likes the regressive tax because he views himself as a positive externality, and the poor and risky as a type of pollution, and that it's optimal to have a system setup that punishes and disciplines the poor in order to reward people like himself. Markets not as a means for allocation or empowerment or broad-based participation, but markets as a form of control and abuse towards the weakest for the benefit of the strongest. But I didn't because I doubt he believes that and I didn't want to make him sound that way.

And I was sure someone would make that point for real. Here's Stephen Spruiell with 'Consumer Financial Protection' in Action:

The old model: Banks use high fees on avoidable behaviors that are nevertheless common among the financially inept, such as account overdrafts, to subsidize free checking accounts and other reward programs for customers who use their accounts responsibly.

The new model: Liberals argue that overdraft fees are abusive and should be banned. Democrats enact new restrictions on overdraft fees. Banks end free checking accounts and other reward programs for responsible customers.

"Inept." First off, I highly doubt Spruiell has seriously read all his consumer financial contracts and understood them completely. Second, I do like the way that he basks in the subsidy. When I was at GMU discussing credit cards with some people, someone mentioned liking the idea that inside his wallet were 3 cards all competing for his attention at the store. Stephen apparently really likes the idea that inside his wallet his debit card is smacking around poor people until they get with it.

Third, people say all kinds of things, but most reformers I know on this issue just want people to be able to opt-out of this service. And that's what the regulation did. And sure enough, BoA is canceling it, presumably because most would opt-out. That's not a government problem, that's a problem that BoA had a product nobody wanted but people needed the checking account and financial services access bundled with it.

FDIC Study

Here's Katherine Mangu-Ward, Pizza, Long-Distance Calls, and the End of Free Checking: "Overdraft fees minimized the losses on the smallest accounts. Now those costs will be spread evenly across people who don't have very much money in the bank."

I'm not sure what that statement means. I think it means that the rich were paying a little bit extra in order to expand banking services to the poorest ("smallest") accounts. If so, that's not true.

Let's pull some data on overdraft from FDIC's Study of Bank Overdraft Programs, November 2008. NSF stands for Non-sufficient funds, which is an overdraft. This is one of many fees you can get charged. On average across all counties that the following study was carried out on, the upper bound for low income bracket is $29,263, medium is $46,821, middle is $70,231 and upper is above that.

First question: Who gets hit with the most fees, and how many NSF fee events do they have?

For low income people, 61.9% don't have any fees. 7.5% have 20 or more fees. As people have more money, they are less likely to get hit by NSF fees in every grouping of transactions. But how much do they end up paying over the course of a year, on average?

You are reading that right. From the first graph, 7.5% of low income people, who make less than $30,000 a year, get hit with 20 or more NSF fees for an average total cost of $1,568. Thank god they didn't have to pay an upfront fee however!

What's important is that the rich pay more or less the same in fees as the poor, but the poor are more likely to pay them. Spruiell believes these fees are from being "inept." Let's take a look at checking balances, on average, through the year:

For low-income people, 56.7% have less than $100 in their checking account when averaged throughout the year. Some will pay $1,568 in order to get a space in the connected economy in order to productive use a balance of $100. Of course someone in these circumstances get hit with overdraft fees, especially if they are getting bombarded with a dozen other fees at the same time.

What's going on with the numerous NSF among the upper and middle income? Part of it might be "inept", though I think in practice it's probably a function of the sweat box mechanism of how consumer credit goes. Bankruptcy has been reengineered, post-2004, to get consumers to have a long, slow drawdown before they are eligible for bankruptcy. This piles on fees, and gives the household more time to see if they can recovery I suppose, but the final product is a slow bleed of their finances through things like banking fees.

The overall reason, however, is that banks used to have a trust element to them, and now it's a vicious rip-the-face-off-the-customer experience. You can argue that you should expect to be ripped off, that it should be your full-time job to guard your money from the bank who is holding it. As my friends at bank simple put it: "I've already got a full-time job, and it should be the bank who looks after my money. That's what banks are for. At least, that's what they used to be for." Somehow we lost the default social norms that kept this a healthy relationship. And things that can make how these funding mechanism are more transparent the better off people will be.

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It's Not the 1930s!

Jun 18, 2010Joe Costello

keynes-150While many are looking back to Keynesian theories, we should be coming up with some that fit our own times.

keynes-150While many are looking back to Keynesian theories, we should be coming up with some that fit our own times.

Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil. -- John Maynard Keynes

As "old" Europe totters on the brink of insolvency, the dead thinking of our modern economic scholastics pervades the political atmosphere to both a degree and detriment as thick and stifling as the Gulf oil slick. The classical school of our economic scholastics states, "If you're insolvent, you must cut spending. You must pay the piper." They are answered from the other side of the cathedral by the self-proclaimed followers of Mr. Keynes, the great classical economic heretic, who scream, "No, the way out of insolvency is to spend more, the government will insure all debt." Neither side seems aware the vaults of the roof of their great cathedral rain down on their heads and the walls crumble. Their beliefs and dogmas from the 19th and 20th centuries offer little practical guidance for the world of the 21st. Unfortunately, that doesn't stop them from fouling the collective political nous, influencing our own generation of madmen in authority.

From almost the beginning, the greatest problem of economics has been its craving for legitimacy as a science, instead of as a system of political values. Birthed at the end of the Enlightenment, when it was in extreme bad taste to found systems of power based on theology, economics looked to science -- which again and again has proved as problematic as any theology for rationalizing systems of power. The classical economics of the 19th century, most specifically the doctrine of laissez-faire, came directly out of the Enlightenment, a continuation of the loosening of the shackles of feudal society begun several centuries before with the Renaissance. At the end of the 18th and beginning of the 19th centuries, the political economy bonds of feudalism remained substantial across Europe. So, as industrial society began to flourish, a doctrine of laissez-faire, of keeping the state away, was logical. Although in reality, as Polanyi clearly documents in The Great Transformation, the state actually played an integral role helping institute the industrial era, and contrary to zealous belief, promoting the doctrine of laissez-faire itself.

The dogma and myths of laissez-faire dominated economic thought for over a century. In the depths of the 1930s global depression, Keynes' great practical heresy was to proclaim the state did indeed have a necessary and active role to play in the economy. Keynes wrote in The General Theory:

Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world...

Whilst, therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism. I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.

Keynes' radicalism, as is so often the case, was simply common sense. Hitting deeper into the established dogma of industrial capital economics, Keynes shattered the notion of "natural" market equilibrium, using the persistent problem of mass unemployment of the mid-30s as refutation. Keynes wrote:

THE outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.

By 1935, when Keynes wrote these words, the world had been in a pronounced period of deflation for almost a decade. Money and debt had undergone massive destruction, accompanied by tremendous industrial and agricultural over-capacity. Keynes' solution was simple: the government should step in and in various ways provide employment and money. It was a common sense solution for a still young industrial society.

The classical economists of the 19th century were writing for their times, just as Mr. Keynes was writing very much for his. In the 19th century, industrialization was just beginning. While wide-spread in the US, Japan, and parts of Europe by the 1930s, it still had a great deal to grow. However, the world of 2010 is far different from the world of the 1930s. The US, Japan, and Western Europe are completely mature industrial societies. This is causing great problems for economic theorists, who insist on using industrial thinking, values, and institutions for problems that are non-industrial in nature, and most importantly, will not respond to the industrial elixir of infinite growth. Unlike his modern disciples, eighty years ago Mr. Keynes broached the growth problem in his Economic Possibilities of Our Grandchildren, though rightfully noting it wasn't a challenge of his time, but for the future.

In the mature industrial West, including Japan, we're not going to solve our great political economy conundrum by simply spending more money and creating more jobs. We have chronic and unhealthy structural problems that need to be addressed. One of the most important structural maleficence, particularly for the United States, is the development of the massive service, or more accurately and detrimentally, "servants" economy. The highest priest of classical economics, Adam Smith, stated in The Wealth of Nations:

Thus the labor of a manufacturer adds, generally, to the value of the materials which he works upon, that of his own maintenance, and of his master's profit. The labor of a menial servant, on the contrary, adds to the value of nothing. A man grows rich by employing a multitude of manufacturers; he grows poor by maintaining a multitude of menial servants.

For the last four decades, under the dogma of industrial market capitalism, the US de-industrialized its economy, destroying the manufacturer, and populating the economy with a vast multitude of menial servants. How was this possible? One word -- debt. In fact, outside of war, it is one of the greatest and most rapid indenturings of a population in human history. The problems of debt, and call it a post-industrial political economy, will not lend themselves well to Keynes' 1930s solutions. Particularly, the rise of the servants economy has proved Keynes wrong on an essential point. Keynes wrote at the end of The General Theory:

I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. It will be, moreover, a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution.

The shifting of the American economy from a manufacturing to a servants economy over the past several decades exploded debt, resulting in a new and almost universal domination by the rentier class. New categories of rent have been created that even a mind as imaginative as Mr. Keynes couldn't have conceived. Most despicably, in what must have Mr. Keynes spinning violently in his grave, the state intervention in the economy over the last couple years has been overwhelmingly to bailout the rentier class and their bad debt, further indenturing the multitude to perpetual servitude. We don't need more debt, we need to destroy much of the bad debt, thus freeing the economy. We need the disappearance of the rentier class, allowing the necessary sea-change. It is time for new ideas to loose the malevolent grip of vested interests.

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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ND20 Alert: FCIC Announces Hearing on Derivatives

Jun 17, 2010

alert-button-150The FCIC is ready to tackle the financial weapons of mass destruction.

alert-button-150The FCIC is ready to tackle the financial weapons of mass destruction.

The Financial Crisis Inquiry Commission today announced that it will hold its next hearing, “The Role of Derivatives in the Financial Crisis," on June 30th and July 1st, this time to investigate derivatives. Warren Buffett himself has warned of the danger of these products, as they tap into the human tendency to gamble with more money than we should. Will the FCIC help uncover the mistakes made and crack down on their use? Tune in to find out!

Before the hearing, read up on New Deal 2.0's coverage of derivatives reform:

"Nailing Down Derivatives, Part One"

"Nailing Down Derivatives, Part Two: Clearinghouses"

"Joe Stiglitz on Derivatives Reform and Section 716"

"How Goldman Will Keep Gaming the System"

"Michael Greenberger on Over-the-Counter Derivatives"

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