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Another Slap On the Wrists

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In case you might be wondering whether the miscreants responsible for causing the financial crisis might ever be prosecuted by Attorney General Eric Hold-harmless – don’t hold your breath.  At the close of 2010, I expressed my disappointment and skepticism that the culprits responsible for having caused the financial crisis would ever be brought to justice.  I found it hard to understand why neither the Securities and Exchange Commission nor the Justice Department would be willing to investigate malefaction, which I described in the following terms:

We often hear the expression “crime of the century” to describe some sensational act of blood lust.  Nevertheless, keep in mind that the financial crisis resulted from a massive fraud scheme, involving the packaging and “securitization” of mortgages known to be “liars’ loans”, which were then sold to unsuspecting investors by the creators of those products – who happened to be betting against the value of those items.  In consideration of the fact that the credit crisis resulting from this scam caused fifteen million people to lose their jobs as well as an expected 8 – 12 million foreclosures by 2012, one may easily conclude that this fraud scheme should be considered the crime of both the last century as well as the current century.

During that same week, former New York Mayor Ed Koch wrote an article which began with the grim observation that no criminal charges have been brought against any of the malefactors responsible for causing the financial crisis:

Looking back on 2010 and the Great Recession, I continue to be enraged by the lack of accountability for those who wrecked our economy and brought the U.S. to its knees.  The shocking truth is that those who did the damage are still in charge.  Many who ran Wall Street before and during the debacle are either still there making millions, if not billions, of dollars, or are in charge of our country’s economic policies which led to the debacle.

“Accountability” is a relative term.  If you believe that the imposition of fines – resulting from civil actions by the Justice Department – could provide accountability for the crimes which led to the financial crisis, then you might have reason to feel enthusiastic.  On the other hand if you agree with Matt Taibbi’s contention that some of those characters deserve to be in prison – then get ready for another disappointment.

Last week, Reuters described plans by the Justice Department to make use of President Obama’s Financial Fraud Task Force (which I discussed last January) by relying on a statute (FIRREA- the Financial Institutions Reform, Recovery, and Enforcement Act) which was passed in the wake of the 1980s Savings & Loan crisis:

FIRREA allows the government to bring civil charges if prosecutors believe defendants violated certain criminal laws but have only enough information to meet a threshold that proves a claim based on the “preponderance of the evidence.”

Adam Lurie, a lawyer at Cadwalader, Wickersham & Taft who worked in the Justice Department’s criminal division until last month, said that although criminal cases based on problematic e-mails without a cooperating witness could be difficult to prove, the same evidence could meet a “preponderance” standard.

On the other hand, William K. Black, who was responsible for many of the reforms which followed the Savings & Loan Crisis, has frequently emphasized that – unlike the 2008 financial crisis – the S&L Crisis actually resulted in criminal prosecutions against those whose wrongdoing was responsible for the crisis.  On December 28, Black characterized the failure to prosecute those crimes which led to the financial crisis as “de facto decriminalization of elite financial fraud”:

The FBI and the DOJ remain unlikely to prosecute the elite bank officers that ran the enormous “accounting control frauds” that drove the financial crisis.  While over 1000 elites were convicted of felonies arising from the savings and loan (S&L) debacle, there are no convictions of controlling officers of the large nonprime lenders.  The only indictment of controlling officers of a far smaller nonprime lender arose not from an investigation of the nonprime loans but rather from the lender’s alleged efforts to defraud the federal government’s TARP bailout program.

What has gone so catastrophically wrong with DOJ, and why has it continued so long?  The fundamental flaw is that DOJ’s senior leadership cannot conceive of elite bankers as criminals.

This isn’t (just) about revenge.  Bruce Judson of the Roosevelt Institute recently wrote an essay entitled “For Capitalism to Survive, Crime Must Not Pay”:

In effect, equal enforcement of the law is not simply important for democracy or to ensure that economic activity takes place, it is fundamental to ensuring that capitalism works.  Without equal enforcement of the law, the economy operates with participants who are competitively advantaged and disadvantaged.  The rogue firms are in effect receiving a giant government subsidy:  the freedom to engage in profitable activities that are prohibited to lesser entities.  This becomes a self-reinforcing cycle (like the growth of WorldCom from a regional phone carrier to a national giant that included MCI), so that inequality becomes ever greater.  Ultimately, we all lose as our entire economy is distorted, valuable entities are crushed or never get off the ground because they can’t compete on a playing field that is not level, and most likely wealth is destroyed.

Does the Justice Department really believe that it is going to impress us with FIRREA lawsuits?  We’ve already had enough theatre – during the Financial Crisis Inquiry Commission hearings and the April 2010 Senate Permanent Subcommittee on Investigations hearing, wherein Goldman’s “Fab Four” testified about selling their customers the Abacus CDO and that “shitty” Timberwolf deal.  It’s time for some “perp walks”.


 

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Scientists Bust the Top One Percent

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Ever since the Occupy Wall Street movement began last fall, we have been hearing the incessant mantra of:  Don’t blame the rich for wealth inequality.  In fact, Herman Cain’s futile bid for the Presidency was based (in part) on that very theme.  Last January, James Q. Wilson (who passed away on Friday) wrote an opinion piece for The Washington Post entitled, “Angry about inequality?  Don’t blame the rich”.  Paul Buchheit of the Common Dreams blog rebutted Wilson’s essay with this posting:  “So say the rich:  ‘Don’t blame us for having all the money!’ ”.  How often have you read and heard arguments from apologists for the Wall Street banksters, upbraiding those who dared speak ill of those sanctified “job creators” within the top one percent of America’s economic strata?

Finally, a group of scientists has intervened by conducting some research about the ethics of those at the top of America’s socioeconomic food chain.  Stéphane Côté, PhD, Associate Professor of Organizational Behavior at the University of Toronto’s Rotman School of Management, worked with a team of four psychologists from the University of California at Berkeley to conduct seven studies on this subject.  Their paper, “Higher social class predicts increased unethical behavior” was published in the February 27 issue of the Proceedings of the National Academy of Sciences (PNAS).  Here is the abstract:

Seven studies using experimental and naturalistic methods reveal that upper-class individuals behave more unethically than lower-class individuals.  In studies 1 and 2, upper-class individuals were more likely to break the law while driving, relative to lower-class individuals.  In follow-up laboratory studies, upper-class individuals were more likely to exhibit unethical decision-making tendencies (study 3), take valued goods from others (study 4), lie in a negotiation (study 5), cheat to increase their chances of winning a prize (study 6), and endorse unethical behavior at work (study 7) than were lower-class individuals.  Mediator and moderator data demonstrated that upper-class individuals’ unethical tendencies are accounted for, in part, by their more favorable attitudes toward greed.

The impact and the timing of this article, with respect to the current debate over income inequality, have resulted in quite a bit of interesting commentary.  I enjoyed the perspective of Peter Dorman at the Econospeak blog:

The tone of the first wave of commentary, as far as I can tell, is that we knew it all along – rich people are nasty.  I would like to put in a word, however, for the other direction of causality, that dishonesty and putting one’s own interests ahead of others are conducive to wealth.

*   *   *

The reason I bring this up is because there is a constant background murmur in our society that says that greater wealth has to be a reward for more talent, more effort or more contribution to society.

Most of the commentary written about the PNAS article has been relatively non-partisan.  Two-day access for reading the article on-line will cost you ten bucks.  For those of us who can’t afford that (as well as for those who can afford it – but are too greedy to pay for anything) I have assembled a number of excerpts from articles written by those who actually read the entire scientific paper.  The following passages will provide you with some interesting details about the research conducted by this group.

Christopher Shea of The Wall Street Journal gave us a brief peek at some of the specific findings of the studies conducted by this team.

It went so far as to show that higher-class people will literally take candy from the mouths of children.

An excerpt quoted by Shea illustrated how the group expanded on an observation made by French sociologist Émile Durkheim:

 “From the top to the bottom of the ladder, greed is aroused,” Durkheim famously wrote.  Although greed may indeed be a motivation all people have felt at points in their lives, we argue that greed motives are not equally prevalent across all social strata.

Brandon Keim of Wired offered us more research data from the article, while focusing on the observations of team member Paul Piff, a Berkeley psychologist:

“This work is important because it suggests that people often act unethically not because they are desperate and in the dumps, but because they feel entitled and want to get ahead,” said evolutionary psychologist and consumer researcher Vladas Griskevicius of the University of Minnesota, who was not involved in the work.  “I am especially impressed that the findings are consistent across seven different studies with varied methodologies.  This work is not just good science, but it is shows deeper insight into the reasons why people lie, cheat, and steal.”

According to Piff, unethical behavior in the study was driven both by greed, which makes people less empathic, and the nature of wealth in a highly stratified society.  It insulates people from the consequences of their actions, reduces their need for social connections and fuels feelings of entitlement, all of which become self-reinforcing cultural norms.

“When pursuit of self-interest is allowed to run unchecked, it can lead to socially pernicious outcomes,” said Piff, who noted that the findings are not politically partisan.  “The same rules apply to liberals and conservatives.  We always control for political persuasion,” he said.

For Thomas B. Edsall of The New York Times, the research performed by this group helped explain the rationale behind a bit of Republican campaign strategy:

Republicans recognize the political usefulness of objectification, capitalizing on “compassion fatigue,” or the exhaustion of empathy, among large swathes of the electorate who are already stressed by the economic collapse of 2008, high levels of unemployment, an epidemic of foreclosures, stagnant wages and a hyper-competitive business arena.

Compassion fatigue was fully evident in Rick Santelli’s 2009 rant on CNBC denouncing a federal plan to prop up “losers’ mortgages” at taxpayer expense, a rant that helped spark the formation of the Tea Party.  Republican debates provided further evidence of compassion fatigue when audiences cheered the record-setting use of the death penalty in Texas and applauded the prospect of a gravely ill pauper who, unable to pay medical fees, was allowed to die.

Jonathan Gitlin of Ars Technica reported on some of the juicy details from a few experiments.  When reading about my favorite experiment, keep in mind that the term “SES” refers to socioeconomic status.

Study number four involved participants rating themselves on the SES scale to heighten their perception of status; they were then answered a number of questions relating to unethical behavior.  At the end of the experiment, they were presented with a jar of individually wrapped candy and told that, although it was for children in a nearby lab, they could take some if they wanted.  At this point you might be able to guess what the results were.  High SES participants took more candy.

Gitlin concluded his review of the paper with this thought:

The researchers argue that “the pursuit of self-interest is a more fundamental motive among society’s elite, and the increased want associated with greater wealth and status can promote wrongdoing.”  However, they point out that their findings aren’t absolute, and that philanthropic efforts such as those of Bill Gates and Warren Buffet buck the observed trend, as does research which has shown a relationship between poverty and violent crime.

Meanwhile, the debate over economic inequality continues to rage on through the 2012 election cycle.  It will be interesting to observe whether this scientific report is exploited to bolster the argument that most of the one-percenters suffer from a character flaw, which not only got them where they are today – but which is shared by their kleptocratic comrades, who have facilitated a system of legalized predation.


 

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Discipline Problem

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At the conclusion of a single, five-year term as Chair of the Federal Deposit Insurance Corporation (FDIC) Sheila Bair is calling it quits.  One can hardly blame her.  It must have been one hell of an experience:  Warning about the hazards of the subprime mortgage market, being ignored and watching the consequences unfold . . .  followed by a painful, weekly ritual, which gave birth to a website called Bank Fail Friday.

Bair’s tenure at the helm of the FDIC has been – and will continue to be – the subject of some great reading.  On her final day at the FDIC (July 8) The Washington Post published an opinion piece by Ms. Bair in which she warned that short-term, goal-directed thinking could bring about another financial crisis.  She also had something to brag about.  Despite the efforts of Attorney General Eric Hold-harmless and the Obama administration to ignore the malefaction which brought about the financial crisis and allowed the Wall Street villains to profiteer from that catastrophe, Bair’s FDIC actually stepped up to the plate:

This past week, the FDIC adopted a rule that allows the agency to claw back two years’ worth of compensation from senior executives and managers responsible for the collapse of a systemic, non-bank financial firm.

To date, the FDIC has authorized suits against 248 directors and officers of failed banks for shirking their fiduciary duties, seeking at least $6.8 billion in damages.  The rationales the executives come up with to try to escape accountability for their actions never cease to amaze me.  They blame the failure of their institutions on market forces, on “dead-beat borrowers,” on regulators, on space aliens.  They will reach for any excuse to avoid responsibility.

Mortgage brokers and the issuers of mortgage-based securities were typically paid based on volume, and they responded to these incentives by making millions of risky loans, then moving on to new jobs long before defaults and foreclosures reached record levels.

The difference between Sheila Bair’s approach to the financial/economic crisis and that of the Obama Administration (whose point man has been Treasury Secretary “Turbo” Tim Geithner) was analyzed in a great article by Joe Nocera of The New York Times entitled, “Sheila Bair’s Bank Shot”.  The piece was based on Nocera’s “exit interview” with the departing FDIC Chair.  Throughout that essay, Nocera underscored Bair’s emphasis on “market discipline” – which he contrasted with Geithner’s fanatic embrace of the exact opposite:  “moral hazard” (which Geithner first exhibited at the onset of the crisis while serving as President of the Federal Reserve of New York).  Nocera made this point early in the piece:

On financial matters, she seemed to have better political instincts than Obama’s Treasury Department, which of course is now headed by Geithner.  She favored “market discipline” – meaning shareholders and debt holders would take losses ahead of depositors and taxpayers – over bailouts, which she abhorred.  She didn’t spend a lot of time fretting over bank profitability; if banks had to become less profitable, postcrisis, in order to reduce the threat they posed to the system, so be it.  (“Our job is to protect bank customers, not banks,” she told me.)

Bair’s discussion of those early, panic-filled days during September 2008 is consistent with reports we have read about Geithner elsewhere.  This passage from Nocera’s article is one such example:

For instance, during the peak of the crisis, with credit markets largely frozen, banks found themselves unable to roll over their short-term debt.  This made it virtually impossible for them to function.  Geithner wanted the F.D.I.C. to guarantee literally all debt issued by the big bank-holding companies – an eye-popping request.

Bair said no.  Besides the risk it would have entailed, it would have also meant a windfall for bondholders, because much of the existing debt was trading at a steep discount.  “It was unnecessary,” she said.  Instead, Bair and Paulson worked out a deal in which the F.D.I.C. guaranteed only new debt issued by the bank-holding companies.  It was still a huge risk for the F.D.I.C. to take; Paulson says today that it was one of the most important, if underrated, actions taken by the federal government during the crisis.  “It was an extraordinary thing for us to do,” Bair acknowledged.

Back in April of 2009, the newly-appointed Treasury Secretary met with similar criticism in this great article by Jo Becker and Gretchen Morgenson at The New York Times:

Last June, with a financial hurricane gathering force, Treasury Secretary Henry M. Paulson, Jr. convened the nation’s economic stewards for a brainstorming session.  What emergency powers might the government want at its disposal to confront the crisis? he asked.

Timothy F. Geithner, who as president of the New York Federal Reserve Bank oversaw many of the nation’s most powerful financial institutions, stunned the group with the audacity of his answer.  He proposed asking Congress to give the president broad power to guarantee all the debt in the banking system, according to two participants, including Michele Davis, then an assistant Treasury secretary.

The proposal quickly died amid protests that it was politically untenable because it could put taxpayers on the hook for trillions of dollars.

“People thought, ‘Wow, that’s kind of out there,’ ” said John C. Dugan, the comptroller of the currency, who heard about the idea afterward.  Mr. Geithner says, “I don’t remember a serious discussion on that proposal then.”

But in the 10 months since then, the government has in many ways embraced his blue-sky prescription.  Step by step, through an array of new programs, the Federal Reserve and Treasury have assumed an unprecedented role in the banking system, using unprecedented amounts of taxpayer money, to try to save the nation’s financiers from their own mistakes.

Geithner’s utter contempt for market discipline again became a subject of the Nocera-Bair interview when the conversation turned to the infamous Maiden Lane III bailouts.

“I’ve always wondered why none of A.I.G.’s counterparties didn’t have to take any haircuts.  There’s no reason in the world why those swap counterparties couldn’t have taken a 10 percent haircut.  There could have at least been a little pain for them.”  (All of A.I.G.’s counterparties received 100 cents on the dollar after the government pumped billions into A.I.G.  There was a huge outcry when it was revealed that Goldman Sachs received more than $12 billion as a counterparty to A.I.G. swaps.)

Bair continued:  “They didn’t even engage in conversation about that.  You know, Wall Street barely missed a beat with their bonuses.”

“Isn’t that ridiculous?” she said.

This article by Gretchen Morgenson provides more detail about Geithner’s determination that AIG’s counterparties receive 100 cents on the dollar.  For Goldman Sachs – it amounted to $12.9 billion which was never repaid to the taxpayers.  They can brag all they want about paying back TARP – but Maiden Lane III was a gift.

I was surprised that Sheila Bair – as a Republican – would exhibit the same sort of “true believer-ism” about Barack Obama as voiced by many Democrats who blamed Rahm Emanuel for the early disappointments of the Obama administration.  Near the end of Nocera’s interview, Bair appeared taken-in by Obama’s “plausible deniability” defense:

“I think the president’s heart is in the right place,” Bair told me.  “I absolutely do.  But the dichotomy between who he selected to run his economic team and what he personally would like them to be doing – I think those are two very different things.”  What particularly galls her is that Treasury under both Paulson and Geithner has been willing to take all sorts of criticism to help the banks.  But it has been utterly unwilling to take any political heat to help homeowners.

The second key issue for Bair has been dealing with the too-big-to-fail banks. Her distaste for the idea that the systemically important banks can never be allowed to fail is visceral.  “I don’t think regulators can adequately regulate these big banks,” she told me.  “We need market discipline.  And if we don’t have that, they’re going to get us in trouble again.”

If Sheila Bair’s concern is valid, the Obama administration’s track record for market discipline has us on a certain trajectory for another financial crisis.



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Post-Free-Market Reality

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The problem became obvious at the onset of the financial crisis.  All of the huffing and puffing about our glorious Free Market system was a big lie.  Once the credit bubble had burst, former Treasury Secretary Hank Paulson went into panic mode – his eyes bulging outward even more than normal.  During that fateful week of September 15 2008, Paulson had 24 telephone conversations with Lloyd Blankfein, his successor CEO at Goldman Sachs.  AIG had to get bailed out at taxpayer expense.  From across the pond, the reaction was immediate.  On September 18 2008, Philip Broughton wrote an article for the Daily Mail entitled, “Free-market capitalism lies shredded … while America’s confidence is badly shaken”.  Near the outset of the piece, Broughton chronicled the ugly truth:

For years now, we have had to listen to bankers attacking Washington for imposing regulations that inhibit the free markets from making even more money.

And all the while, they took exorbitant salaries, justifying them on the grounds of their huge contribution to capitalism.

How bitterly ironic it is, then, to see these one-time freemarketeers becoming socialists overnight.

The schoolyard bullies of Wall Street have gone running to the state for help, pleading to be saved from destruction.

They deserve neither our sympathy nor the billions in taxpayer support they are now receiving.

That theme has been reverberating through commentaries ever since.

A year later, Paul Farrell of MarketWatch provided an overview of writings by Jack Bogle, Marc Faber and Thomas Moore to support his contention that “America’s Soul of Capitalism” has been lost:

You know something’s very wrong:  A year ago, too-greedy-to-fail banks were insolvent, in a near-death experience.  Now, magically, they’re back to business as usual, arrogant, pocketing outrageous bonuses while Main Street sacrifices, and unemployment and foreclosures continue rising as tight credit, inflation and skyrocketing federal debt are killing taxpayers.

Down in Australia, The Propitious Manager wrote an essay on April 4 2010, expressing his amazement that America was having so much trouble trying to stomach the idea of government-backed healthcare:

When you read President O’bama’s healthcare plan the most striking message is the failure of a free market to provide for the community. The healthcare market in the US, left unfettered to run free, just crashes into a heap of mismanagement, inefficiency and opportunism (hold on – isn’t this a familiar story).  I’ll leave you to read the script – but it isn’t a pretty picture.

*   *   *

What I like to call post free market economies, are about identifying the markets which are essential to maintaining thriving people and communities and develop the frameworks which optimize their performance.  Some require complete freedom while others require varying degrees of framework from elected governments.  Developing an increasingly sophisticated community and social framework is really the challenge of the century.  One where it doesn’t matter whether your a rubbish collector or a billionaire – if you get sick, someone will care for you and if you invest your money it will be there when you wake up in the morning.

The idea that we are now living in a post-free-market economy presents itself in a recent commentary by Veronique de Rugy for Bloomberg News, entitled “Why Businesses Can’t Stand Free Markets”.  Ms. De Rugy discussed how businesses exploit regulatory capture and use lobbyists to obtain favorable laws and regulations in order to stifle competition at the expense of consumers.  She concluded with this thought:

Let’s hope that any court ruling deals a blow to the practice of entrenched businesses using government to impose higher costs on consumers while also thwarting upstart entrepreneurs.  No one said loving free markets was easy.

On the other hand, there are many “upstart entrepreneurs” seeking government assistance to circumvent obstacles existing in the free-market system.  This has become especially apparent in the burgeoning solar power industry, where American upstarts are attempting to compete with entities which obtain government financing – not only in China but in the eurozone as well.  Martin LaMonica recently discussed this problem in an article for CNET:

Before the financial crisis, solar challengers were able to build manufacturing facilities using private money–venture capital, private equity, and hedge funds.  These sources still exist, but private investors are being pickier about how they place their bets, said Ted Sullivan, solar analyst at Lux Research.

Raising money on the public markets with an initial public offering was possible a few years ago, too, but is very difficult now, said Ethan Zindler, head of policy analysis at Bloomberg New Energy Finance.  Banks, meanwhile, are unlikely to finance the first factory for a solar company if the technology is relatively new and untested.

That leaves government programs, such as low-cost loans, and state incentives for economic development to help fill the financing gap in many cases.

*   *   *

In an effort to stimulate exports, the China Development Bank has made $40 billion in credit available to six solar companies in the past six months, said Zindler from Bloomberg New Energy Finance.  The U.S. stimulus program made billions of dollars available to stimulate clean-energy technologies, but the U.S. can’t match the amount of money China has made available through these low-cost loans, he said.

“Chinese solar companies are grinding down the cost by building plants the size the world has never seen before and deploying unbelievable amounts of capital to do it,” Zindler said.

In the U.S., the solar industry scored a victory with the passage of the tax bill last week because it included a one-year extension to a grant that replaces a tax credit subsidy.  But it’s unclear what the long-term direction on renewable energy policy is in the U.S., which creates questions over how strong demand will be for solar, Zindler said.

In our post-free-market milieu, there are many exceptions to the general rule that government assistance to business is a bad thing.  Now that people are finally facing up to the reality that many companies (some of which are Cayman Islands-based corporations) have been receiving U.S. government subsidies (of some sort) for decades, difficult decisions must be made to determine when this is appropriate and when it’s not.  American voters need to face up to the fact that many of those poseurs claiming to be champions of “American free enterprise” are nothing more than hypocritical tools for whoever is lining their pockets.  “American free enterprise” died at Maiden Lane.  Deal with it.



Two Years Too Late

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October 11, 2010

Greg Gordon recently wrote a fantastic article for the McClatchy Newspapers, in which he discussed how former Treasury Secretary Hank Paulson failed to take any action to curb risky mortgage lending.  It should come as no surprise that Paulson’s nonfeasance in this area worked to the benefit of Goldman Sachs, where Paulson had presided as CEO for the eight years prior to his taking office as Treasury Secretary on July 10, 2006.  Greg Gordon’s article provided an interesting timeline to illustrate Paulson’s role in facilitating the subprime mortgage crisis:

In his eight years as Goldman’s chief executive, Paulson had presided over the firm’s plunge into the business of buying up subprime mortgages to marginal borrowers and then repackaging them into securities, overseeing the firm’s huge positions in what became a fraud-infested market.

During Paulson’s first 15 months as the treasury secretary and chief presidential economic adviser, Goldman unloaded more than $30 billion in dicey residential mortgage securities to pension funds, foreign banks and other investors and became the only major Wall Street firm to dramatically cut its losses and exit the housing market safely.  Goldman also racked up billions of dollars in profits by secretly betting on a downturn in home mortgage securities.

By now, the rest of that painful story has become a burden for everyone in America and beyond.  Paulson tried to undo the damage to Goldman and the other insolvent, “too big to fail” banks at taxpayer expense with the TARP bailouts.  When President Obama assumed office in January of 2009, his first order of business was to ignore the advice of Adam Posen (“Temporary Nationalization Is Needed to Save the U.S. Banking System”) and Professor Matthew Richardson.  The consequences of Obama’s failure to put those “zombie banks” through temporary receivership were explained by Karen Maley of the Business Spectator website:

Ireland has at least faced up to the consequences of the reckless lending, unlike the United States.  The Obama administration has adopted a muddle-through approach, hoping that a recovery in housing prices might mean that the big US banks can avoid recognising crippling property losses.

*   *   *

Leading US bank analyst, Chris Whalen, co-founder of Institutional Risk Analytics, has warned that the banks are struggling to cope with the mountain of problem home loans and delinquent commercial property loans.  Whalen estimates that the big US banks have restructured less than a quarter of their delinquent commercial and residential real estate loans, and the backlog of problem loans is growing.

This is eroding bank profitability, because they are no longer collecting interest on a huge chunk of their loan book.  At the same time, they also face higher administration and legal costs as they deal with the problem property loans.

Banks nursing huge portfolios of problem loans become reluctant to make new loans, which chokes off economic activity.

Ultimately, Whalen warns, the US government will have to bow to the inevitable and restructure some of the major US banks.  At that point the US banking system will have to recognise hundreds of billions of dollars in losses from the deflation of the US mortgage bubble.

If Whalen is right, Ireland is a template of what lies ahead for the US.

Chris Whalen’s recent presentation, “Pictures of Deflation” is downright scary and I’m amazed that it has not been receiving the attention it deserves.  Surprisingly — and ironically – one of the only news sources discussing Whalen’s outlook has been that peerless font of stock market bullishness:  CNBC.   Whalen was interviewed on CNBC’s Fast Money program on October 8.  You can see the video here.  The Whalen interview begins at 7 minutes into the clip.  John Carney (formerly of The Business Insider website) now runs the NetNet blog for CNBC, which featured this interview by Lori Ann LoRocco with Chris Whalen and Jim Rickards, Senior Managing Director of Market Intelligence at Omnis, Inc.  Here are some tidbits from this must-read interview:

LL:  Chris, when are you expecting the storm to hit?

CW:  When the too big to fail banks can no longer fudge the cost of restructuring their real estate exposures, on and off balance sheet. Q3 earnings may be the catalyst

LL:  What banks are most exposed to this tsunami?

CW:  Bank of America, Wells Fargo, JPMorgan, Citigroup among the top four.  GMAC.  Why do we still refer to the ugly girls — Bank of America, JPMorgan and Wells Fargo in particular — as zombies?  Because the avalanche of foreclosures and claims against the too-big-too-fail banks has not even crested.

*   *   *

LL:  How many banks to expect to fail next year because of this?

CW:  The better question is how we will deal with the process of restructuring.  My view is that the government/FDIC can act as receiver in a government led restructuring of top-four banks.  It is time for PIMCO, BlackRock and their bond holder clients to contribute to the restructuring process.

Of course, this restructuring could have and should have been done two years earlier — in February of 2009.  Once the dust settles, you can be sure that someone will calculate the cost of kicking this can down the road — especially if it involves another round of bank bailouts.  As the saying goes:  “He who hesitates is lost.”  In this case, President Obama hesitated and we lost.  We lost big.



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The Smell Of Rotting TARP

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September 16, 2010

I never liked the TARP program.  As we approach the second anniversary of its having been signed into law by President Bush, we are getting a better look at how really ugly it has been.  Marshall Auerback picked up a law degree from Corpus Christi College, Oxford University in 1983 and currently serves as a consulting strategist for RAB Capital Plc in addition to being an economic consultant to PIMCO.  Mr. Auerback recently wrote a piece for the Naked Capitalism website in response to a posting by Ben Smith at Politico.  Smith’s piece touted the TARP program as a big success, with such statements as:

The consensus of economists and policymakers at the time of the original TARP was that the U.S. government couldn’t afford to experiment with an economic collapse.  That view in mainstream economic circles has, if anything, only hardened with the program’s success in recouping the federal spending.

Marshall Auerback’s essay, rebutting Ben Smith’s piece, was entitled, “TARP Was Not a Success —  It Simply Institutionalized Fraud”.  Mr. Auerback began his argument this way:

Indeed, the only way to call TARP a winner is by defining government sanctioned financial fraud as the main metric of results.  The finance leaders who are guilty of wrecking much of the global economy remain in power – while growing extraordinarily wealthy in the process.  They know that their primary means of destruction was accounting “control fraud”, a term coined by Professor Bill Black, who argued that “Control frauds occur when those that control a seemingly legitimate entity use it as a ‘weapon’ to defraud.”  TARP did nothing to address this abuse; indeed, it perpetuates it.  Are we now using lying and fraud as the measure of success for financial reform?

After pointing out that “Congress adopted unprincipled accounting principles that permit banks to lie about asset values in order to hide their massive losses on loans and investments”, Mr. Auerback concluded by enumerating the steps followed to create an illusion of viability for those “zombie banks”:

Both the Bush and Obama administration followed a three-part strategy towards our zombie banks:  (1) cover up the losses through (legalized) accounting fraud, (2) launch an “everything is great” propaganda campaign (the faux stress tests were key to this tactic and Ben Smith perpetuates this nonsense in his latest piece on TARP), and (3) provide a host of secret taxpayer subsidies to the systemically dangerous institutions (the so-called “too big to fail” banks).  This strategy is the opposite of what the Swedes and Norwegians did during their banking crisis in the 1990s, which remains the template on a true financial success.

Despite this sleight-of-hand by our government, the Moment of Truth has arrived.  Alistair Barr reported for MarketWatch that it has finally become necessary for the Treasury Department to face reality and crack down on the deadbeat banks that are not paying back what they owe as a result of receiving TARP bailouts.  That’s right.  Despite what you’ve heard about what a great “investment” the TARP program supposedly has been, there is quite a long list of banks that cannot boast of having paid back the government for their TARP bailouts.  (Don’t forget that although Goldman Sachs claims that it repaid the government for what it received from TARP, Goldman never repaid the $13 billion it received by way of Maiden Lane III.)  The MarketWatch report provided us with this bad news:

In August, 123 financial institutions missed dividend payments on securities they sold to the Treasury Department under the Troubled Asset Relief Program, or TARP.  That’s up from 55 in November 2009, according to Keefe, Bruyette & Woods.

More important —  of those 123 financial institutions, seven have never made any TARP dividend payments on securities they sold to the Treasury.  Those seven institutions are:  Anchor Bancorp Wisconsin, Blue Valley Ban Corp, Seacoast Banking Corp., Lone Star Bank, OneUnited Bank, Saigon National Bank and United American Bank.  The report included this point:

Saigon National is the only institution to have missed seven consecutive quarterly TARP dividend payments.  The other six have missed six consecutive payments, KBW noted.

The following statement from the MarketWatch piece further undermined Ben Smith’s claim that the TARP program was a great success:

Most of the big banks have repaid the TARP money they got and the Treasury has collected about $10 billion in dividend payments from the effort.  However, the rising number of smaller banks that are struggling to meet dividend payments shows the program hasn’t been a complete success.

Of course, the TARP program’s success (or lack thereof) will be debated for a long time.  At this point, it is important to take a look at the final words from the “Conclusion” section (at page 108) of a document entitled, September Oversight Report (Assessing the TARP on the Eve of its Expiration), prepared by the Congressional Oversight Panel.  (You remember the COP – it was created to oversee the TARP program.)  That parting shot came after this observation at page 106:

Both now and in the future, however, any evaluation must begin with an understanding of what the TARP was intended to do.  Congress authorized Treasury to use the TARP in a manner that “protects home values, college funds, retirement accounts, and life savings; preserves home ownership and promotes jobs and economic growth; [and] maximizes overall returns to the taxpayers of the United States.”  But weaknesses persist.  Since EESA was signed into law in October 2008, home values nationwide have fallen.  More than seven million homeowners have received foreclosure notices.  Many Americans’ most significant investments for college and retirement have yet to recover their value.  At the peak of the crisis, in its most significant acts and consistent with its mandate in EESA, the TARP provided critical support at a time in which confidence in the financial system was in freefall.  The acute crisis was quelled.  But as the Panel has discussed in the past, and as the continued economic weakness shows, the TARP’s effectiveness at pursuing its broader statutory goals was far more limited.

The above-quoted passage, as well as these final words from the Congressional Oversight Panel’s report, provide a  greater degree of candor than  what can be seen in Ben Smith’s article:

The TARP program is today so widely unpopular that Treasury has expressed concern that banks avoided participating in the CPP program due to stigma, and the legislation proposing the Small Business Lending Fund, a program outside the TARP, specifically provided an assurance that it was not a TARP program.  Popular anger against taxpayer dollars going to the largest banks, especially when the economy continues to struggle, remains high.  The program’s unpopularity may mean that unless it can be convincingly demonstrated that the TARP was effective, the government will not authorize similar policy responses in the future.  Thus, the greatest consequence of the TARP may be that the government has lost some of its ability to respond to financial crises in the future.

No doubt.



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Doctor Doom Writes A Prescription

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May 6, 2010

As I discussed on April 26, expectations for serious financial reform are pretty low.  Worse yet, Lloyd Blankfein (CEO of Goldman Sachs) felt confident enough to make this announcement, during a conference call with private wealth management clients:

“We will be among the biggest beneficiaries of reform.”

So how effective could “financial reform” possibly be if Lloyd Bankfiend expects to benefit from it?  Allan Sloan of Fortune suggested following the old Wall Street maxim of “what they promise you isn’t necessarily what you get” when examining the plans to reform Wall Street:

President Obama talks about “a common sense, reasonable, nonideological approach to target the root problems that led to the turmoil in our financial sector and ultimately in our entire economy.”  But what we’ll get from the actual legislation isn’t necessarily what we hear from the Salesman-in-Chief.

Sloan offered an alternative by providing “Six Simple Steps” to help fix the financial system.  He wasn’t alone in providing suggestions overlooked by our legislators.

Nouriel Roubini (often referred to as “Doctor Doom” because he was one of the few economists to anticipate the scale of the financial crisis) has written a new book with Stephen Mihm entitled, Crisis Economics:  A Crash Course in the Future of Finance.  (Mihm is a professor of economic history and a New York Times Magazine writer.)  An excerpt from the book recently appeared in The Telegraph.  The idea of fixing our “sub-prime financial system” was introduced this way:

Even though they have suffered the worst financial crisis in generations, many countries have shown a remarkable reluctance to inaugurate the sort of wholesale reform necessary to bring the financial system to heel.  Instead, people talk of tinkering with the financial system, as if what just happened was caused by a few bad mortgages.

*   *   *

Since its founding, the United States has suffered from brutal banking crises and other financial disasters on a regular basis.  Throughout the 19th and early 20th centuries, crippling panics and depressions hit the nation again and again.  The crisis was less a function of sub-prime mortgages than of a sub-prime financial system.  Thanks to everything from warped compensation structures to corrupt ratings agencies, the global financial system rotted from the inside out.  The financial crisis merely ripped the sleek and shiny skin off what had become, over the years, a gangrenous mess.

Roubini and Mihm had nothing favorable to say about CDOs, which they referred to as “Chernobyl Death Obligations”.  Beyond that, the authors called for more transparency in derivatives trading:

Equally comprehensive reforms must be imposed on the kinds of deadly derivatives that blew up in the recent crisis.  So-called over-the-counter derivatives — better described as under-the-table — must be hauled into the light of day, put on central clearing houses and exchanges and registered in databases; their use must be appropriately restricted.  Moreover, the regulation of derivatives should be consolidated under a single regulator.

Although derivatives trading reform has been advanced by Senators Maria Cantwell and Blanche Lincoln, inclusion of such a proposal in the financial reform bill faces an uphill battle.  As Ezra Klein of The Washington Post reported:

The administration, the Treasury Department, the Federal Reserve, and even the FDIC are lockstep against it.

The administration, Treasury and the Fed are also fighting hard against a bipartisan effort to include an amendment in the financial reform bill that would compel a full audit of the Federal Reserve.  I’m intrigued by the possibility that President Obama could veto the financial reform bill if it includes a provision to audit the Fed.

Jordan Fabian of The Hill discussed Congressman Alan Grayson’s theory about why Treasury Secretary Tim Geithner opposes a Fed audit:

But Grayson, who is known for his tough broadsides against opponents, indicated Geithner may have had a role in enacting “secret bailouts and loan guarantees” to large corporations, while New York Fed chairman during the Bush administration.

“It’s one of the biggest conflict of interests I have ever seen,” he said.

With the Senate and the administration resisting various elements of financial reform, the recent tragedy in Nashville provides us with a reminder of how history often repeats itself.  The concluding remarks from the Roubini – Mihm piece in The Telegraph include this timely warning:

If we strengthen the levees that surround our financial system, we can weather crises in the coming years. Though the waters may rise, we will remain dry.  But if we fail to prepare for the inevitable hurricanes — if we delude ourselves, thinking that our antiquated defences will never be breached again — we face the prospect of many future floods.

The issue of whether our government will take the necessary steps to prevent another financial crisis continues to remain in doubt.



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Unrealistic Expectations

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April 22, 2010

Newsweek’s Daniel Gross is back at it again.  His cover story for Newsweek’s April 9 issue is another attempt to make a preemptive strike at writing history.  You may remember his cover story for the magazine’s July 25 issue, entitled:  “The Recession Is Over”.  During the eight months since the publication of that article, the sober-minded National Bureau of Economic Research, or NBER —  which is charged with making the determination that a recession has ended – has yet to make such a proclamation.

The most recent cover story by Daniel Gross, “The Comeback Country” has drawn plenty of criticism.  (The magazine cover used the headline “America’s Back” to introduce the piece.)  At The Huffington Post, Dan Dorfman discussed the article with Olivier Garret, the CEO of Casey Research, an economic and investment consulting firm.  Garret described the Newsweek cover story as “fantasy journalism” and he shared a number of observations with Dan Dorfman:

“You know when a magazine like Newsweek touts a bullish economic recovery on its cover, just the opposite is likely to be the case,” he says.  “It sees superficial signs of improvement, but it’s ignoring the big picture.”

*   *   *

Meanwhile, Garret sees additional signs of economic anguish.  Among them:  More foreclosures and delinquencies of real estate properties will plague construction spending; banks haven’t yet cleaned up their balance sheets; private debt is no longer going down as it did in 2009; both short and long term rates should be headed higher, and many companies, he says, tell him they’re reluctant to invest and hire.

He also sees some major corporate bankruptcies, worries about the country’s ability to repay its debt, looks for rising cost of capital, which should further slow the economy, and expects a spreading sovereign debt crisis.

*  *  *

Many economists are projecting GDP growth in the range of 3% to 4% in the first quarter and similar growth for the entire year.  Much too optimistic, Garret tells me.  His outlook (which would clobber the stock market if he’s right):  up 0.4%-0.5% in the first quarter after revisions and between 0% and 1% for all of 2010.

“Fantasy economies only work in the mind, not in real life,” he says.

Given his bleak economic outlook, Garret expects a major market adjustment, say about a 10% to 20% decline in stock prices over the next six months.  He figures it could be triggered by one event, such as as an extension of the sovereign debt crisis.

David Cottle of The Wall Street Journal had this reaction to the Newsweek article:

Therefore, when you see a cover such as Newsweek’s recent effort, yelling “America’s Back” in no uncertain terms, it’s quite tempting to stock up on bonds, cash, tinned goods and ammunition.

Now, in fairness to the author, Daniel Goss, he makes the good point that the U.S. economy is growing at a clip that has consistently surprised gloomy forecasters.  It is.  The turnaround we’ve seen since Lehman Brothers imploded has been remarkable, if not entirely satisfying, he says, and he is quite right.  At the very least, U.S. growth is all-too-predictably leaving the European version in the dust.  Goss is also pretty upfront about the corners of the U.S. economy that have so far failed to keep up:  job creation and the housing market being the most obvious.

However, the problem with all these ‘back to normal’ pieces, and Goss’s is only one of many creeping out as the sky resolutely fails to fall in, is that the ‘normal’ they want to go back to was, in reality, anything but.

The financial sector remains unreformed, the global economy remains dangerously unbalanced.  The perilous highways that brought us to 2007 have not been sealed off in favor of straighter, if slower, roads.  Of course it would be great for us all if America were ‘back’ and so we must hope Newsweek’s cover doesn’t join the ranks of those which cruel history renders unintentionally hilarious .

But back where?  That’s the real question.

Meanwhile, the Pew Research Center has turned to Americans themselves to find out just how “back” America really is.  This report from April 20 didn’t seem to resonate so well with the rosy picture painted by Daniel Gross:

Americans are united in the belief that the economy is in bad shape (92% give it a negative rating), and for many the repercussions are hitting close to home.  Fully 70% of Americans say they have faced one or more job or financial-related problems in the past year, up from 59% in February 2009.  Jobs have become difficult to find in local communities for 85% of Americans.  A majority now says that someone in their household has been without a job or looking for work (54%); just 39% said this in February 2009. Only a quarter reports receiving a pay raise or a better job in the past year (24%), while almost an equal number say they have been laid off or lost a job (21%).

As economic conditions continue to deteriorate for middle-class Americans, the first few months of 2009 are already looking like “the good old days”.   The “comeback” isn’t looking too good.



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The Goldman Fallout

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April 19, 2010

In the aftermath of the disclosure concerning the Securities and Exchange Commission’s fraud suit against Goldman Sachs, we have heard more than a little reverberation of Matt Taibbi’s “vampire squid” metaphor, along with plenty of concern about which other firms might find themselves in the SEC’s  crosshairs.

As Jonathan Weil explained for Bloomberg News :

As Wall Street bombshells go, the lawsuit that the Securities and Exchange Commission filed against Goldman Sachs Group Inc. is about as big as it gets.

At The Economist, there was a detectable scent of schadenfreude in the discussion, which reminded readers that despite Lloyd Blankfein’s boast of having repaid Goldman’s share of the TARP bailout, not everyone has overlooked Maiden Lane III:

IS THE most powerful and controversial firm on Wall Street about to get the comeuppance that so many think it deserves?

*   *   *

The charges could hardly come at a worse time for Goldman.  The firm has been under fire on a number of fronts, including over the handsome payout it secured from the New York Fed as a derivatives counterparty of American International Group, an insurer that almost failed in 2008.  In a string of negative articles over the past year, Goldman has been accused of everything from double-dealing for its own advantage to planting its own people in the Treasury and other agencies to ensure that its interests were looked after.

At this point, those who criticized Matt Taibbi for his tour de force against Goldman (such as Megan McArdle) must be experiencing a bit of remorse.  Meanwhile, those of us who wrote items appearing at GoldmanSachs666.com are exercising our bragging rights.

The complaint filed against Goldman by the SEC finally put to rest the tired old lie that nobody saw the financial crisis coming.  The e-mails from Goldman VP, Fabrice Tourre, made it perfectly clear that in addition to being aware of the imminent collapse, some Wall Street insiders were actually counting on it.  Jonathan Weil’s Bloomberg article provided us with the translated missives from Mr. Tourre:

“More and more leverage in the system.  The whole building is about to collapse anytime now,” Fabrice Tourre, the Goldman Sachs vice president who was sued for his role in putting together the deal, wrote on Jan. 23, 2007.

“Only potential survivor, the fabulous Fab …  standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!”

A few weeks later, Tourre, now 31, e-mailed a top Goldman trader:  “the cdo biz is dead we don’t have a lot of time left.”  Goldman closed the Abacus offering in April 2007.

Michael Shedlock (a/k/a Mish) has quoted a number of sources reporting that Goldman may soon find itself defending similar suits in Germany and the UK.

Not surprisingly, there is mounting concern over the possibility that other investment firms could find themselves defending similar actions by the SEC.  As Anusha Shrivastava reported for The Wall Street Journal, the action in the credit markets on Friday revealed widespread apprehension that other firms could face similar exposure:

Credit markets were shaken Friday by the news as investors tried to figure out whether other firms or other structured finance products will be affected.

Investors are concerned that the SEC’s action may create a domino effect affecting other firms and other structured finance products.  There’s also the worry that this regulatory move may rattle the recovery and bring uncertainty back to the market.

“Credit markets are seeing a sizeable impact from the Goldman news,” said Bill Larkin, a portfolio manager at Cabot Money Management, in Salem, Mass.  “The question is, has the S.E.C. discovered what may have been a common practice across the industry?  Is this the tip of the iceberg?”

*  *  *

The SEC’s move marks “an escalation in the battle to expose conflicts of interest on Wall Street,” said Chris Whalen of Institutional Risk Analytics in a note to clients.  “Once upon a time, Wall Street firms protected clients and observed suitability …  This litigation exposes the cynical, savage culture of Wall Street that allows a dealer to commit fraud on one customer to benefit another.”

The timing of this suit could not have been better – with the Senate about to consider what (if anything) it will do with financial reform legislation.  Bill Black expects that this scandal will provide the necessary boost to get financial reform enacted into law.  I hope he’s right.



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Getting It Reich

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April 8, 2010

Robert Reich, former Secretary of Labor under President Clinton, has been hitting more than a few home runs lately.   At a time when too many commentators remain in lock-step with their favorite political party, Reich pulls no punches when pointing out the flaws in the Obama administration’s agenda.  I particularly enjoyed his reaction to the performance of Larry Summers on ABC television’s This Week on April 4:

I’m in the “green room” at ABC News, waiting to join a roundtable panel discussion on ABC’s weekly Sunday news program, This Week.

*   *   *

Larry Summers was interviewed just before Greenspan. He said the economy is expanding, that the Administration is doing everything it can to bring jobs back, and that the regulatory reform bills moving on the Hill will prevent another financial crisis.

What?

*   *   *

If any three people are most responsible for the failure of financial regulation, they are Greenspan, Larry Summers, and my former colleague, Bob Rubin.

*   *   *

I dislike singling out individuals for blame or praise in a political system as complex as that of the United States but I worry the nation is not on the right economic road, and that these individuals — one of whom advises the President directly and the others who continue to exert substantial influence among policy makers — still don’t get it.

The direction financial reform is taking is not encouraging.  Both the bill that emerged from the House and the one emerging from the Senate are filled with loopholes that continue to allow reckless trading of derivatives.  Neither bill adequately prevents banks from becoming insolvent because of their reckless trades.  Neither limits the size of banks or busts up the big ones.  Neither resurrects the Glass-Steagall Act. Neither adequately regulates hedge funds.

More fundamentally, neither bill begins to rectify the basic distortion in the national economy whose rewards and incentives are grotesquely tipped toward Wall Street and financial entrepreneurialism, and away from Main Street and real entrepreneurialism.

Is it because our elected officials just don’t understand what needs to be done to prevent another repeat of the financial crisis – or is the unwillingness to take preventative action the result of pressure from lobbyists?  I think they’re just playing dumb while they line their pockets with all of that legalized graft. Meanwhile, Professor Reich continued to function as the only adult in the room, with this follow-up piece:

Needless to say, the danger of an even bigger cost in coming years continues to grow because we still don’t have a new law to prevent what happened from happening again.  In fact, now that they know for sure they’ll be bailed out, Wall Street banks – and those who lend to them or invest in them – have every incentive to take even bigger risks.  In effect, taxpayers are implicitly subsidizing them to do so.

*   *   *

But the only way to make sure no bank it too big to fail is to make sure no bank is too big.  If Congress and the White House fail to do this, you have every reason to believe it’s because Wall Street has paid them not to.

Reich’s recent criticism of the Federal Reserve was another sorely-needed antidote to Ben Bernanke’s recent rise to media-designated sainthood.  In an essay quoting Republican Senator Jim DeMint of South Carolina, Reich transcended the polarized political climate to focus on the fact that the mysterious Fed enjoys inappropriate authority:

The Fed has finally came clean.  It now admits it bailed out Bear Stearns – taking on tens of billions of dollars of the bank’s bad loans – in order to smooth Bear Stearns’ takeover by JP Morgan Chase.  The secret Fed bailout came months before Congress authorized the government to spend up to $700 billion of taxpayer dollars bailing out the banks, even months before Lehman Brothers collapsed.  The Fed also took on billions of dollars worth of AIG securities, also before the official government-sanctioned bailout.

The losses from those deals still total tens of billions, and taxpayers are ultimately on the hook.  But the public never knew.  There was no congressional oversight.  It was all done behind closed doors. And the New York Fed – then run by Tim Geithner – was very much in the center of the action.

*   *   *

The Fed has a big problem.  It acts in secret.  That makes it an odd duck in a democracy.  As long as it’s merely setting interest rates, its secrecy and political independence can be justified. But once it departs from that role and begins putting billions of dollars of taxpayer money at risk — choosing winners and losers in the capitalist system — its legitimacy is questionable.

You probably thought that Ron Paul was the only one who spoke that way about the Federal Reserve.  Fortunately, when people such as Robert Reich speak out concerning the huge economic and financial dysfunction afflicting America, there is a greater likelihood that those with the authority to implement the necessary reforms will do the right thing.  We can only hope.



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