New Sheriffs in Town

May 13, 2010Lynn Parramore

sheriff-150TIME hails three women gunning for better ways to do business.

sheriff-150TIME hails three women gunning for better ways to do business.

At New Deal 2.0, we're fortunate in having the voice of the man known as the Sheriff of Wall Street, Eliot Spitzer. But we've also got one of the three women Time Magazine has named to carry the mantle in the post-crisis era, Elizabeth Warren.

Michael Scherer confirms what ND20 contributors like Nomi Prins (Women Reformers Motivated by a No Tolerance Rule) and Joe Costello (Top Five Heroes of Financial Reform) have been saying for some time: Women are at the forefront of changing the way we do business in America. They've been calling for tougher regulation in the Senate. They've been blowing the whistle (despite suffering greater retaliation for their trouble). And they've been setting the example.

As Scherer makes clear, TARP watchdog Warren, along with FDIC chair Shelia Bair and SEC chair Mary Schapiro "may not run Wall Street, but in this new era, they are telling Wall Street how to clean up its act."

The whys and wherefores are complex. As outsiders, perhaps, women can less afford to mess around with the rules and tend to keep to the straight and narrow because they don't have the protection of an old-boy-network. But because they have less to hide, they have more credibility in identifying and addressing wrongdoing. On Wall Street, as in any male-dominated culture, they also tend to be less secure of their jobs. So they're less likely to take outsized risks that could backfire, and tend to think longer-term.

Frankly, as women, we put up with a lot. If we go far, we've most likely learned to overcome being passed over, devalued, and attacked. That makes for some tough broads.

Also, the status quo is not as friendly to the ladies, so we have less incentive to preserve it. Speaking of the New Sheriffs, Scherer writes:

It is their willingness to break ranks and challenge the status quo that makes these increasingly powerful women different from their predecessors...Under financial regulatory reform, which all three women support, both the SEC and the FDIC stand to win powerful new authority to limit and dismantle offenders. The Consumer Financial Protection Agency, a proposed body now working its way through the Senate, is the brainchild of Warren and is envisioned as a bulwark against what she calls the "tricks and traps" that banks hide in credit-card agreements and mortgages.

Elizabeth Warren, who recently participated in the Roosevelt Institute's Make Markets Be Markets conference and will soon be joining as Senior Fellow, has brought her tenacity and plain-spoken smarts to bear in a way that has no doubt left many in the Senate ruing the day they put her in charge of TARP. Scherer observes:

Warren has wielded her clout like a cudgel, releasing monthly reports demanding more information from Treasury, better investment returns from the banks and greater efforts to help borrowers. Warren's relations with Treasury officials and the banks have often been strained, sometimes by the harshness of her panel's critiques. She remembers talking in early 2009 with an official on Capitol Hill -- she won't say whom -- who told her point-blank, "That's not what reports are supposed to look like." She asked, "Why not?" The reply: "The language is far too direct."

Not for the New Sheriff it ain't.

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Amendments in Play for Financial Reform, 5/13

May 13, 2010Mike Konczal

Overview

David Dayen has an overview of what pieces are still in play:

Overview

David Dayen has an overview of what pieces are still in play:

There is no question that lobbyists are gunning for Merkley-Levin, which would end reckless trading out of the proprietary accounts of banks which receive deposit insurance and cheap money from the discount window. The vote, expected tomorrow, will be extremely close. And that amendment is not alone: the Dorgan amendment which would force an advisory board to break up any firm that presents a systemic risk; the Dorgan amendment banning naked credit default swaps; the Cantwell-McCain amendment restoring the Glass-Steagall firewall between investment and commercial banks; the Franken amendment reforming the credit rating agencies. All of these improvements to the bill are legitimate and not cosmetic, and represent the difference between a bill politicians can wave around and a bill that regulators can actually use.

The difference between this being a really strong, a really so-so, and a really weak bill is still up in the air in the Senate and committee.

Potential Bad News, Derivatives

Disappointing move of the day, Brian Beutler is reporting what I had feared (my bold):

One of the most far-reaching pieces of the Senate's Wall Street reform bill has powerful enemies. The White House doesn't like it. FDIC chief Sheila Bair doesn't like it. Obama adviser Paul Volcker--the patron saint of financial reform--doesn't like it. And neither do a number of key Democrats, including Banking Committee Chairman Chris Dodd. All of them say that a controversial proposal to force financial firms to spin off their derivative-trading desks into separate entities goes too far.

But they may have gotten themselves stuck with it--at least for now. With their assent, the plan was authored by Sen. Blanche Lincoln (D-AR), who designed it to guard her left flank against a somewhat formidable primary challenge, and has been boasting of it on populist grounds for weeks. And that according to Republican and Democratic Senate sources, has led Democrats to quietly agree to postpone any changes they decide to make to her proposal until after this Tuesday's election has passed, to avoid embarrassing her in front of voters.

The Chambliss amendment to severely weaken derivatives reform was beaten yesterday, which made me optimistic that they could get derivatives out the door relatively unscathed. But now this. So the question is, in order, will they drop Section 106, which spins out swap dealers from commercial banks, will they drop the new fiduciary requirements, will they weaken clearing requirements by expanding end-users and will they mess with the definition of what constitutes an exchange and/or clearing?

Collins Amendment

Senator Collins has an amendment on leverage, text here. It's sadly not a 15-to-1 requirement as far as I can read it, but it does show promise in forcing the largest banks to actually hold as much if not more capital than smaller less risky firms.

Because even better than a strict 15-to-1 cap is a graduated leverage requirement, and Collins' amendment gets closer to there. Press release: "Neither current law nor the Senate Banking Committee bill requires regulators to adjust capital standards for risk factors as financial institutions grow in size or engage in risky practices", and it directly alludes to the regulatory arbitrage: "It does not make sense that under current law, the nation's largest banks and bank holding companies are not required to meet the same capital standards imposed on smaller depository banks, when the failure of larger institutions is much more likely to have a broad economic impact."

Interchange

Durbin has an amendment, being voted on today, about interchange fees, which is a hobbyhorse of mine. (Resources: here's an interview, my coverage of the latest GAO report, comments on a PBS documentary, and a two part list of other points.) I've been told over and over again that interchange is an impossibility to move, and here there is movement.

Here is a press release, here is an information sheet. Note a few things: It impacts debit card fees for regulation, and not credit card fees. This is the right approach - credit cards are an unsecured revolving line of credit and thus the business can do whatever, but debit cards represent your money, and having to pay a giant institution 2%, and increasing, rate to move your money from point A to point B through a mechanism that is the new standard for money interaction needs to change.

This amendment also gives merchants the ability to charge different prices for different types of cards. It's amazing how much a little bit of transparency and a little bit of choice can jumpstart a market and diffuse the problems of duopoly we have been seeing here. And this amendments gives both.

Also note, because you'll hear it a lot, "The Durbin amendment would not enable merchants to discriminate against debit cards issued by small banks and credit unions. Visa and MasterCard contractually require merchants to accept all cards within their networks, and the amendment does not change that requirement."

All Amendments

Senator Franken has an amendment to regulate the ratings agencies, which he discussed with Ezra Klein here.

Edmund Andrews talks about state consumer pre-emption here, must read for the topic.

Ezra has the list of amendments:

Here's what the Senate is considering adding to the financial-regulation bill:

* Collins amendment to mandate minimum leverage and risk-based capital requirements for insured depository institutions, depository institution holding companies, and nonbank financial companies that the Council identifies for Board of Governors supervision and as subject to prudential standards. (#3879)

* Brownback amendment to provide for an exclusion from the authority of the Bureau of Consumer Financial Protection for certain automobile manufacturers, and for other purposes. (#3789, as modified)

* Snowe-Pryor amendment to ensure small business fairness and regulatory transparency. (#3883)

* Specter amendment to amend section 20 of the Securities and Exchange Act of 1934 to allow for a private civil action against a person that provides substantial assistance in violation of such Act (#3776, as modified)

* Leahy amendment to restore the application of the Federal antitrust laws to the business of health insurance to protect competition and consumers. (#3823)

* Sessions amendment to provide an orderly and transparent bankruptcy process for non-bank financial institutions and prohibit bailout authority. (#3832)

* Durbin amendment to ensure that the fees that small businesses and other entities are charged for accepting debit cards are reasonable and proportional to the costs incurred, and to limit payment card networks from imposing anti-competitive restrictions on small businesses and other entities that accept payment cards. (#3989)

* Franken amendment to instruct the Securities and Exchange Commission to establish a self-regulatory organization to assign credit rating agencies to provide initial credit ratings. (#3991)

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

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Chris Hayes Takes Over Maddow, Takes on Ben Bernanke

May 12, 2010

"Something incredible happened in Washington today," says a flabbergasted Chris Hayes, Nation editor and ND20 contributor. Hayes subbed for Rachel Maddow and discussed the passage of the "audit the Fed" amendment, the "single greatest act of bipartisanship since Obama took office." The amendment passed the Senate 96-0 -- which means that all senators present, Democrats, Republicans and Independents alike, voted for it.

So what is an audit of the Fed? When the economy started melting down, the Fed started loaning money to all sorts of people it had never lent money to before. And "most troubling of all," Chris points out, it wouldn't say who it gave it to or how much. And if that sounds crazy -- "That's because it is crazy." Ben Bernanke "just plain wouldn't tell who the Fed was giving money to."

The quest for transparency has "given rise to the ultimate strange bedfellows political coalition," with the likes of Jane Hamsher, Grover Norquist, Congressman Alan Grayson, and Congressman Ron Paul. And now all of the Senators present for the vote.

Guest Senator Bernie Sanders of Vermont, the sponsor of the amendment, joined him to explain further.

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

"Something incredible happened in Washington today," says a flabbergasted Chris Hayes, Nation editor and ND20 contributor. Hayes subbed for Rachel Maddow and discussed the passage of the 'audit the Fed' amendment, the "single greatest act of bipartisanship since Obama took office." The amendment passed the Senate 96-0 -- which means that all senators present -- Democrats, Republicans and Independents alike -- voted for it.

So what is an audit of the Fed? When the economy started melting down, the Fed started loaning money to all sorts of people it had never lent money to before. And "most troubling of all," Hayes points out, it wouldn't say who it gave it to or how much. And if that sounds crazy -- "That's because it is crazy." Ben Bernanke "just plain wouldn't tell who the Fed was giving money to."

The quest for transparency has "given rise to the ultimate strange bedfellows political coalition," with the likes of Jane Hamsher, Grover Norquist, Congressman Alan Grayson, and Congressman Ron Paul. And now all of the Senators present for the vote.

Guest Senator Bernie Sanders of Vermont, the sponsor of the amendment, joined him to explain further.


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

Watch the rest of the show here.

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The Curse of Bigness: Reform will be Distributed

May 12, 2010Joe Costello

brandeis-150If we don't break up the banks, can we ever break the hold they have over our economy?

brandeis-150If we don't break up the banks, can we ever break the hold they have over our economy?

Both liberty and democracy are seriously threatened by the growth of big business. Today the need is not so much for freedom from physical restraint as for freedom from economic oppression. Already the displacement of the small independent businessman by the huge corporation with its myriad of employees, its absentee ownership, and its financier control, presents a grave danger to our democracy. The social loss is great; and there is no economic gain. Political liberty, then, is not enough; it must be attended by economic and industrial liberty.

There is no such thing as freedom for a man who under normal conditions is not financially free. We must therefore find means to create in the individual financial independence against sickness, accidents, unemployment, old age, and the dread of leaving his family destitute, if he suffers premature death. For we have become practically, a world of employees; and, if a man is to have real freedom of contract in dealing with his employer, he must be financially independent of these ordinary contingencies. Unless we protect him from this oppression, it is foolish to call him free. -- Louis Brandeis

The other evening I was watching Bill Maher and observed something unprecedented. Maher's guest, historian Alan Brinkley, brought up, for the first time I have ever heard on television, Louis Brandeis' insight on the "curse of bigness" in political economy. Brandeis was a leading figure of the early 20th century Progressive era, who understood the Jeffersonian imperative that democracy was inherently decentralized and individuals needed political/economic independence if they were to be citizens of any system of self-government.

Maher raised the topic in relation to Brinkley's writing on the 1930s Pecora Commission, which uncovered the tremendous amount of fraud underlying the collapse of the financial system in the late 1920s and early 1930s. Brinkley has also written on the great compromise of the New Deal, which was to lay aside concerns of economic concentration in a trade-off for centralized regulation. Over time this has proved fatally flawed -- big corporations took over big government.

Unfortunately, the discussion on bigness was immediately dismissed, first by Brinkley, who unfortunately turned to channeling effete liberalism, throwing up his hands and claiming nothing could be done. Then secondly by the lizard-like former Bush speech writer David Frum. I will say again, the intellectual dishonesty of our political class is horrendously nauseating, and make no mistake, it's bipartisan. Mr. Frum stated no need to worry because, "The Fortune 1000 employ fewer people than ever." True, but they also control a greater piece of GDP than ever. In 2006, "Revenue from Fortune 500 companies as a proportion of GDP has risen from 39 percent in 1955 to 73.4 percent this year." At the same time, the percentage of the American workforce employed by the Fortune 500 has fallen to just 8%. The vast vast majority of people in this country do not work for the Fortune 500 or Fortune 1000. Each year the majority competes for an ever smaller share of the economic pie, which is what Mr. Frum left out. You can also add the six biggest banks in this country control over 60% of deposits. This, plain and simple, is oligarchy.

We are only going to get reform of our political economy by breaking up power, decentralizing both corporate and government power. Unfortunately, Mr. Brinkley is not alone in throwing up his hands and claiming nothing can be done. Nonetheless, the breaking up of bigness is the only legitimate reform. The rest is simply a charade. Can you imagine if the generation that birthed this republic had thrown up their hands and claimed, "There's nothing to be done about the King, he's too big!" This attitude infests our political class, who, unlike the majority of citizens, actually do work for the Fortune 500.

The American system was established with power decentralized. Today, we have an advantage over both the founding generation and Mr. Brandeis': we have learned new ways of organization, we understand beneficial order can be gained from the bottom up. For example, distributed networked organization has revolutionized electronic media, offering lessons for our entire political economy. But it must be instilled with political will and courage; as Mr. Brandeis stated, "Progress flows only from struggle."

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: Elizabeth Warren at SEIU Event Tomorrow in D.C.

May 12, 2010

alert-button-150ND20 contributor Elizabeth Warren will talk about how people can get involved with financial reform. If you're in D.C., show your support this Thursday!

alert-button-150ND20 contributor Elizabeth Warren will talk about how people can get involved with financial reform. If you're in D.C., show your support this Thursday!

Harvard Law Professor Elizabeth Warren and members and leaders of SEIU and National People's Action will discuss how policy leaders and everyday Americans must work to keep Wall Street recklessness in check and rebuild America's economy and the middle class.

Warren, a fierce consumer advocate, has been watching out for ordinary folks that Wall Street has preyed upon (See her posts, Feminomics: Women and Bankruptcy; New Agenda for America: The Great Lesson).

And in case you missed it, check out Warren's electrifying presentation at the Roosevelt Institute's  Make Markets Be Markets conference and watch her bring down the house on The Daily Show.

Thursday's event occurs as Wall Street reform is being debated before the Senate and days before thousands of Americans descend on Washington, D.C. to take on the lobbyists and their allies working for Wall Street CEOs and corporate interests.

Here are the details:

WHO: Elizabeth Warren, Harvard Law School Leo Gottlieb Professor of Law, SEIU and National People's Action Members and Leaders

WHAT: Elizabeth Warren, workers, and activists discuss how policy leaders and everyday Americans must work to build a sustained campaign to reform America's economic system.

WHEN: May 13, 2010

2pm ET

WHERE: SEIU

1800 Massachusetts Ave, NW

Washington, D.C. 20036

RSVP HERE.

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Dean Baker on Rachel Maddow: Wall Street's Cred is "Shattered"

May 10, 2010

Dean Baker discusses the tarnished reputation of Wall Street, which he says has been "shattered" by scandals like Bernie Madoff and Goldman Sachs. "People don't need investment banks to rip them off, anyone can do that. So why should they go to Wall Street?" If we want to compete with other markets around the world, we have to "clean it up."

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

Dean Baker discusses the tarnished reputation of Wall Street, which he says has been  "shattered" by scandals like Bernie Madoff and Goldman Sachs. "People don't need investment banks to rip them off, anyone can do that. So why should they go to Wall Street?" If we want to compete with other markets around the world, we have to "clean it up."


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

Check out recent New Deal 2.0 pieces on Dean Baker's views:

Dean Baker on Sub-optimal Financial Reform: ‘The Scare Stories Worked"

Dean Baker Speaks About Auditing the Fed

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Why You Should Be Against Pre-Emption Deals.

May 10, 2010Mike Konczal

Keep an eye out for a deal that would allow for pre-emption of state consumer financial protection laws by federal regulators, a rumored development that should disturb financial reformers. The CFPA at the Fed seemed to be in a good position, with Dodd working to make it as strong as possible while being housed at the Fed, efforts to replace it with something ineffectual defeated, and a potential last minute move to bring it out of the Fed.

Keep an eye out for a deal that would allow for pre-emption of state consumer financial protection laws by federal regulators, a rumored development that should disturb financial reformers. The CFPA at the Fed seemed to be in a good position, with Dodd working to make it as strong as possible while being housed at the Fed, efforts to replace it with something ineffectual defeated, and a potential last minute move to bring it out of the Fed. But if allowing the CFPA to preempt state laws is in the works, that's really bad for the overall effort to the idea of consumer financial protection.

Here is a letter from Elizabeth Warren and Illinois Attorney General Lisa Madigan:

Wal-mart operates in all 50 states, but it doesn’t come to Washington insisting that Congress protect it from state laws that demand workplace safety or environmental standards. As far as the law is concerned, they compete straight up with the local businesses–no special favors. What the big banks are really saying is that they are already spending $1.4 million a day just to block federal reform, and they don’t want to spend more money blocking state laws too. Washington lobbyists don’t want to have to have to venture out into real America; they are comfortable inside the Beltway....

The states were the first and often the only responders to the oncoming foreclosure crisis. Beginning more than a decade ago, [Illinois] brought enforcement actions against subprime mortgage giants such as Household, Ameriquest, and Countrywide for illegal conduct, while the federal regulators did nothing to rein in the lenders under their control. States also moved swiftly to enact tougher laws where federal inaction had left a void. It is imperative that the states be able to protect our citizens from abuses in the marketplace. In a time of global economic crisis, we clearly need more enforcers of consumer protection laws, not fewer.

Here's some stuff I wrote on preemption and the nightmare it created for Georgia earlier.  Why is preemption worth fighting against, which is to say why should states be able to write consumer financial protection laws against national banks?

Local Knowledge: Texas is not Wisconsin is not Vermont is not Florida. States themselves have both better knowledge of their local economies and the policy tools to address issues occurring locally. This should not be controversial.

I think there will be a fair amount of research over the next decade on this topic, but preliminarily evidence is that tougher consumer protection laws, particularly those centered around home equity loan restrictions and prepayment penalties, helped prevent a massive wave of foreclosures. The Dallas Federal Reserve found that: "Due to the state’s strong predatory lending laws and restrictions on mortgage equity withdrawals, a smaller share of Texas’ subprime loans involve cash-out refinancing, which reduces homeowner equity and makes default more likely when mortgage payments become unaffordable..."

We looked at Vermont's consumer protection laws in a similar light here. Whatever the motivation for these practices - Texas' laws date back to Homestead Act of 1839, an accident of history - they are by far our best first line of response to consumer protection.

Consumer Activism: In terms of making political changes, activists are far more effective at the state level than at the federal level. Here's Kate Sheppard writing about anti-poverty, religious, and consumer advocacy groups partnering up to protest payday loan lenders in Virginia. It's impossible to imagine such a group being as effective at the federal level, especially the more grassroots it was.

Game Theory: You have two regulators, the state and the federal government, they are in conflict. The federal government is easier to corrupt: you can bribe 1 federal regulator with 50x the money of 50 state regulators; and in so much as bad regulation may be felt more heavily at the state level, there's even more of a incentive misalignment. If they are forced to compete, because the entity being regulated can choose, it's even more favorable to that entity. One way to solve these nasty equilibria is to choose the stronger regulation proposed between the two parties, which is what happens when you exclude pre-emption.

Corruption: I will take it for granted that it is easier for there to be corruption at the federal level than at the state level. The elections are more expensive, the tenure is too strong. And if it is forced to be the law of the entire country through pre-emption, the more it will necessarily have to cover (since the states will be unlikely to try). And you don't want states to be subject to the whims of banker captured beltway insiders.

So what's the argument for? The best argument is that national banks don't want to have 50 legal divisions to have offices in 50 different states. If Texas is not Wisconsin, then you need a Texas law team and a Wisconsin law team. This is excellent business logic for large banks, as it forces through law a return to scale on their legal infrastructure. However we don't make laws to benefit how profitable being large is to national banks - we make laws to make sure contracts are valid and well-informed, that property rights that involve debt and uncertainty are maintained properly and that borrowing and lending market are as complete as they can be without being exploitive. In so much as this amendment hurts our ability to do those things and all we get in return is that shareholders of the largest national banks get a slightly better return, this approach is a terrible deal.

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

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SAFE Banking Amendment Fails in Senate

May 10, 2010Mike Konczal

The SAFE Banking Amendment failed in a snap vote 33 to 61. Matt Taibbi has comments on it. A few random thoughts:

The SAFE Banking Amendment failed in a snap vote 33 to 61. Matt Taibbi has comments on it. A few random thoughts:

- David Dayen: "Only, outside of a couple upstart groups like A New Way Forward, the progressive movement determined it not a cause worth fighting for. It’s just a plain fact that breaking up the mega-banks would have 10,000 times the impact of the public option – or auditing the Fed, for that matter – and absolutely nobody in the progressive coalition cared."

A New Way Forward deserves a round of applause for the work they put into this, as does everyone else who wrote, organized and fought for it. But the administration was against this amendment from the get go. When even Austan Goolsbee tells American Banker that size won't be a priority for their Too Big To Fail policy, it's about as all hands on deck as you can get. The administration is even against the leverage cap in the SAFE Banking Amendment, worried it would tie our regulators hands when they go to negotiate Basel III. Treasury Secretary Geithner has circulated letters saying that having a hard leverage cap would ruin "flexibility" of the regulators "to successfully negotiate a robust international leverage ratio" that doesn't "leave U.S. firms at a competitive disadvantage to their foreign peers."

- This is an old battle in financial reform for liberals. To what extent should you break up and silo large banking oligarchies and to what extent should you codify and accept the oligarchy and try to manage them? From Ellis W. Hawley's The New Deal and the Problem of Monopoly (1966):

On one hand, there was a growing belief that banking was one of the "natural monopolies," one of those areas of economic endeavor that should be centralized and then subjected to strict controls or transferred to the state...

The anti-trusters found it difficult to agree among themselves...from the standpoint of the economic planners, most of the Brandeisian ideas were either meaningless or positively harmful. As they saw it the solicitude shown for little banks and manteur bankers seemed only to weaken the banking system, lower the quality of its services, and prevent its integration into a program of centralized planning. The efforts to subsidize small business and promote decentralization were essentially wasteful and futile. And the attempts to promote fair practices and business honesty bore little relation to the real problem of economic concentration. They did nothing...about the problem of mobilizing capital and regulating its use.

As we've discussed before, FDR was able to make an interesting split where he didn't create a highly concentrated private banking industry like most other industrialized countries. I think this administration's course of action between these two choices was settled in favor of the large concentration with Diana Farrell's quote: "We have created them [our biggest banks], and we’re sort of past that point, and I think that in some sense, the genie’s out of the bottle and what we need to do is to manage them and to oversee them, as opposed to hark back to a time that we’re unlikely to ever come back to or want to come back to.”

Here's hoping that this doesn't go the opposite of Farrell's goal, and that the banks aren't the ones that will manage and oversee the regulators. Here's hoping prudential regulation and the threat of resolution are credible on a firm with nondeposit liabilities equal to 6, 7 or 8% of GDP as well as significant political power. Because if it isn't, and they get capital cheaper from that, we just got a bunch of new GSE-like firms in the financial economy. If the silo-ing of business lines gets gutted in the Senate, which we will find out this week, we are basically going into a new future for the American financial economy that will look depressingly like what we've just come from.

- Even Hank Paulson says: "In our haste to deal with the flaws in the non-bank financial system, we should not move ourselves back to a system of consolidated, monolithic commercial banks." I assume that the word monolithic was chosen for effect.

- As Simon Johnson points out, in response to the sometimes implicit and sometimes explicit arguments that large, concentrated financial sector will be more stable, self-regulate and respond better to government regulators than a less concentrated one:

Which are the huge global banks that Senator Dodd, Jamie Dimon, and Larry Summers think we should be emulating? Surely not the Chinese – their governance failures are profound and complete; this is state banking run amok. Surely not the British – after all Mervyn King and Adair Turner, the top authorities on those banks, are globally the most articulate officials on how good finance has gone so deeply wrong. Surely not the Canadians – those myths have been long exploded (and without dissent, in our conversations with the Bank of Canada).

And surely you are not proposing that the continental European banks are a model of anything other than ineptness, blind herding, and the transition from being “too big to fail” to “so big that even when you save them, you get an economic catastrophe”?

There's still a lot that can change or stay in the bill, but I do think that the SAFE Amendment failing was a major setback for financial reform.

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

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A Financial Reform Interview Recap

May 7, 2010Mike Konczal

I recently did a series of interview on financial reform. Here are a list of them:

Stephen Lubben speaks about the End User Exemption.

Dean Baker Speaks About Auditing the Fed.

Spinning Out Derivatives Desks with Michael Greenberger.

Jerome Fons speaks about the Ratings Agencies.

Jane D’Arista talks about Volcker Rule.

An Interview with Jennifer Taub on Off-Balance Sheet Reform.

What did I learn from them? Though there is a lot of bluster on both sides of the issue, the case for auditing is wise, practical and makes perfect sense once you lay it out. The stigma issue has been addressed, as there is a large amount of both delay in information release as well as scope of who has access to it. Also the point that the Fed has kicked hard against any type of reform that now seems perfectly normal, like having to give testimony to Congress about what they are up to, gives the stakes that they are putting on this some context.

The Volcker Rule and Off-Balance Sheet reform, issues that are still in play on the Hill, could have cascading effects to build a better financial market. The consequences of both could be to create an atmosphere where there is more honesty, transparency, and client and good service related work.

I think this is important. It's one thing to give regulators more tools to deal within a crisis; it's another thing to start a crisis from happening. The little things have an effect, and they build on each other. Not getting promoted for ripping the face off of a client but instead building a better working relationship trickles into how new employees are trained, and norms shift in a subtle way.

Talking with Lubben made me think we need to radically rethink the way in which corporate America benefits from its relationship with Wall Street. There are services and then there are services. It's one thing to have capital and risk managed in a much more efficient manner. It's another to be able to manipulate your statistics and hide leverage and debt. Like Kevin Drum, I'm not sure an end-user is even a good idea if this is what it does. And this is a larger debate, and one we need to have.

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

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How Goldman Will Keep Gaming the System

May 7, 2010Wallace Turbeville

dollar-box-150While hedging risk can be a useful service, the uneven playing field in derivative trading has long-term dangers. The current financial reform bill won't fix this problem.

dollar-box-150While hedging risk can be a useful service, the uneven playing field in derivative trading has long-term dangers. The current financial reform bill won't fix this problem.

Last week, a Senate Committee thoroughly grilled Goldman Sachs executives regarding a series of mortgage derivatives transactions and, more generally, conflicts of interests in their fundamental business model. Senator Ted Kaufman's closing statement in his exchange with Lloyd Blankfein transcended the specific subject matter:

What really bothers people the most...is not the bailouts.... What bothers them a lot is the incredible compensation for people that made horrible decisions.... What I think really kind of gets them the most is here we are after this terrible travail and there is one section of our entire economy which has so much money that it has to worry what is going to do with billions of dollars for bonuses.... The idea that Wall Street came out of this thing just fine thank you really grates on them... that you gamed this thing really well.

It was an important reminder of the broader context of the inquiry into specific behaviors by Goldman.

Senator Kaufman articulated the public sentiment well. People believe that the big banks are advantaged by an uneven playing field. As is often the case, the collective wisdom of the public is correct. Financial sector profit has grown to 40% of the US total over the last two decades. Innovation in our economy is morphing from production of new products and services to hedging the prices of existing products and services. This does not sound like a sensible strategy for long-term growth. It is a strategy for stagnation, focused on risk aversion and squeezing profits from existing business activity.

The public views the game as so uneven that the only obstacle to unimaginable profits is hubris. The bankers ascribe success to superior intellect and intrepidity and believe that they can manage any risk (notwithstanding the recent evidence to the contrary). A more detached analysis tells us that the primary reason for success is a market structure that favors financial institutions.

A player sometimes loses, even if the uneven field favors him. This should humble him and change his behavior. Unfortunately, the potential humbling effect of the financial crisis was diminished by the unavoidable bail out of the financial sector. Behavior did not change materially. In fact, Mr. Blankfein has told his associates and shareholders that Goldman plans to profit in the future by following its existing business model.

The uneven playing field is undoubtedly a short-term benefit to the health of financial institutions. However, the long-term effects are in fact dangerous. In the hearings, the Senators gave tribute to the intellect of the investment bankers. However, while history suggests that they are smart enough to exploit immediate opportunities, it also tells us that they are not smart (or wise) enough to understand the imperfection of quantitative analysis. Use of ingenious algorithms requires a heavy dose of judgment, not swagger. After all, since no one knows all of the underlying factors, the algorithms may accurately measure conditions which do not exist (remember the mortgage bonds). Bias toward exploiting immediate advantages (fueled by this year's bonus) can color judgments. The bankers may be just smart enough to assure that their future failures will be monumental.

An excellent example of an unbalanced system is the market for hedging corporate price risk, referred to in the pending financial reform legislation as "end user" transactions and mentioned by Senator Kaufman.

The wave of privatization and deregulation during the last several decades has multiplied the number of activities exposed to price risk (more companies with activities in which unfettered market forces determine both their costs and the price of their products and services). As a result, the opportunities to create and trade derivatives based on these price risks have exploded. The number of markets has dramatically increased, but they tend to be narrow and comparatively illiquid.

To mitigate this profusion of price risk, companies have turned to derivatives hedging, prompted by credit rating agencies, among others. This constitutes a target-rich environment for sophisticated and well-capitalized bank traders.

As price risk along the production chain is transferred to a bank, it then owns a substantial portion of the value of the end commodity. For example, assume a power generator uses a derivative to fix the price of gas it needs to fuel a power plant and another to fix the price of the power it will generate. The bank selling the derivatives owns this spread between fuel and power and will manage it over time. The generator's business is in essence limited to operating the facility which converts the gas to electricity. A significant slice of the business of generating power has been sold to the bank at a price.

The problem occurs when these types of transactions are not struck in open, competitive markets. Financial institutions have huge advantages when dealing in derivatives with non-financial companies. Their balance sheets are far better suited to trading derivatives and their ability to extend credit provides great leverage. Using these advantages, banks, either alone or in oligopolies, can use market power to dominate narrow derivatives markets. Taken collectively, large slices of the economic flows migrate to the banks under favorable terms.

As prices of inputs and outputs have migrated to the banks, they have become dominant in large sectors of the economy. Companies have no realistic choice but to hedge. They become dependent on the banks to supply the hedge. The banks are able to charge more for hedges in opaque bi-lateral transactions because of disproportionate market power. A few pennies more in price may not matter to a company that must hedge to survive; but those few pennies on a huge book of business are extremely profitable to a financial institution.

Mr. Blankfein spoke of the public benefits of providing hedges to industrial companies. While financial institutions do provide this useful service, the question is whether the exercise of market power of a limited number of banks operating in shadowy markets is in the interest of the nation. The very level of financial sector profitability suggests that it is not.

Current financial reform legislation does not address this issue if it carves out the end users. The carve-out is sought to avoid required collateralization of exposures. This is a concern, since the exposures are real enough. Posting collateral merely transfers the risk from the shadowy over-the-counter market to the balance sheet of the end user, where it belongs. It eliminates the risk of liquidity death spirals posed by credit based collateralization triggers, common to these transactions. Finally, it eliminates huge end user exposures to bank credit risk, since the banks do not post either. While the inconvenience and cost of posting collateral are valid points, it may be that the dependence on bi-lateral bank transactions to provide hedges is the greater motivation behind end user resistance.

At a minimum, structures should be imposed on the bi-lateral market to mitigate the ability of the financial institutions to exercise market power if the end user carve-out survives. An alternative market structure could provide:

• Central recordation of bi-lateral trade data;

• Daily measurement of credit risk to both sides based on metrics approved by governmental authorities;

• Confirmation that the transactions in fact constitute hedges;

• Standards and mechanisms for required collateralization as circumstances change; and

• Standardized instruments to allow for predictable results in the event of default.

This structure would preserve the essential bi-lateral nature of the transactions. It would, however, allow regulators to view the overall risk exposures to the market participants based on understandable and uniform metrics. Early warning of the potential triggering of collateral calls and the potential liquidity requirement could be crucial to maintaining stability. And, finally, market power in narrow specific markets could be measured and monitored.

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

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