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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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Too Cute By Half

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April 29, 2010

On April 15, I discussed the disappointing performance of the Financial Crisis Inquiry Commission (FCIC).  The vapid FCIC hearings have featured softball questions with no follow-up to the self-serving answers provided by the CEOs of those too-big–to-fail financial institutions.

In stark contrast to the FCIC hearings, Tuesday brought us the bipartisan assault on Goldman Sachs by the Senate Permanent Subcommittee on Investigations.  Goldman’s most memorable representatives from that event were the four men described by Steven Pearlstein of The Washington Post as “The Fab Four”, apparently because the group’s most notorious member, Fabrice “Fabulous Fab” Tourre, has become the central focus of the SEC’s fraud suit against Goldman.   Tourre’s fellow panel members were Daniel Sparks (former partner in charge of the mortgage department), Joshua Birnbaum (former managing director of Structured Products Group trading) and Michael Swenson (current managing director of Structured Products Group trading).  The panel members were obviously over-prepared by their attorneys.  Their obvious efforts at obfuscation turned the hearing into a public relations disaster for Goldman, destined to become a Saturday Night Live sketch.  Although these guys were proud of their evasiveness, most commentators considered them too cute by half.  The viewing public could not have been favorably impressed.  Both The Washington Post’s Steven Pearlstein as well as Tunku Varadarajan of The Daily Beast provided negative critiques of the group’s testimony.  On the other hand, it was a pleasure to see the Senators on the Subcommittee doing their job so well, cross-examining the hell out of those guys and not letting them get away with their rehearsed non-answers.

A frequently-repeated theme from all the Goldman witnesses who testified on Tuesday (including CEO Lloyd Bankfiend and CFO David Viniar) was that Goldman had been acting only as a “market maker” and therefore had no duty to inform its customers that Goldman had short positions on its own products, such as the Abacus-2007AC1 CDO.  This assertion is completely disingenuous.  When Goldman creates a product and sells it to its own customers, its role is not limited to that of  “market-maker”.  The “market-maker defense” was apparently created last summer, when Goldman was defending its “high-frequency trading” (HFT) activities on stock exchanges.  In those situations, Goldman would be paid a small “rebate” (approximately one-half cent per trade) by the exchanges themselves to buy and sell stocks.  The purpose of paying Goldman to make such trades (often selling a stock for the same price they paid for it) was to provide liquidity for the markets.  As a result, retail (Ma and Pa) investors would not have to worry about getting stuck in a “roach motel” – not being able to get out once they got in – after buying a stock.  That type of market-making bears no resemblance to the situations which were the focus of Tuesday’s hearing.

Coincidentally, Goldman’s involvement in high-frequency trading resulted in allegations that the firm was “front-running” its own customers.   It was claimed that when a Goldman customer would send out a limit order, Goldman’s proprietary trading desk would buy the stock first, then resell it to the client at the high limit of the order.  (Of course, Goldman denied front-running its clients.)  The Zero Hedge website focused on the language of the disclaimer Goldman posted on its “GS360” portal.  Zero Hedge found some language in the GS360 disclaimer which could arguably have been exploited to support an argument that the customer consented to Goldman’s front-running of the customer’s orders.

At Tuesday’s hearing, the Goldman witnesses were repeatedly questioned as to what, if any, duty the firm owed its clients who bought synthetic CDOs, such as Abacus.  Alistair Barr of MarketWatch contended that the contradictory answers provided by the witnesses on that issue exposed internal disagreement at Goldman as to what duty the firm owed its customers.  Kurt Brouwer of MarketWatch looked at the problem this way :

This distinction is of fundamental importance to anyone who is a client of a Wall Street firm.  These are often very large and diverse financial services firms that have — wittingly or unwittingly — blurred the distinction between the standard of responsibility a firm has as a broker versus the requirements of an investment advisor.  These firms like to tout their brilliant and objective advisory capabilities in marketing brochures, but when pressed in a hearing, they tend to fall back on the much looser standards required of a brokerage firm, which could be expressed like this:

Well, the firm made money and the traders made money.  Two out of three ain’t bad, right?

The third party referred to indirectly would be the clients who, all too frequently, are left out of the equation.

A more useful approach could involve looking at the language of the brokerage agreements in effect between Goldman and its clients.  How did those contracts define Goldman’s duty to its own customers who purchased the synthetic CDOs that Goldman itself created?  The answer to that question could reveal that Goldman Sachs might have more lawsuits to fear than the one brought by the SEC.



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Failed Financial Reform And Failed Justice

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April 26, 2010

As the long-awaited financial reform legislation finally seems to be headed toward enactment, the groans of disappointment are loud and clear.  My favorite reporter at The New York Times, Gretchen Morgenson, did a fine job of exposing the shortcomings destined for inclusion in this lame bill:

Unfortunately, the leading proposals would do little to cure the epidemic unleashed on American taxpayers by the lords of finance and their bailout partners.  The central problem is that neither the Senate nor House bills would chop down big banks to a more manageable and less threatening size.  The bills also don’t eliminate the prospect of future bailouts of interconnected and powerful companies.

Too big to fail is alive and well, alas.  Indeed, several aspects of the legislative proposals sanction and codify the special status conferred on institutions that are seen as systemically important.  Instead of reducing the number of behemoth firms assigned this special status, the bills would encourage smaller companies to grow large and dangerous so that they, too, could have a seat at the bailout buffet.

*   *   *

It is disappointing that none of the current proposals call for breaking up institutions that are now too big or on their way there.  Such is the view of Richard W. Fisher, president of the Federal Reserve Bank of Dallas.

“The social costs associated with these big financial institutions are much greater than any benefits they may provide,” Mr. Fisher said in an interview last week.  “We need to find some international convention to limit their size.”

*   *   *

Edward Kane, a finance professor at Boston College and an authority on financial institutions and regulators, said that it was not surprising that substantive changes for both groups are not on the table.  After all, powerful banks want to maintain their ability to privatize gains and socialize losses.

“To understand why defects in in solvency detection and resolution persist, analysts must acknowledge that large financial institutions invest in building and exercising political clout,” Mr.Kane writes in an article, titled “Defining and Controlling Systemic Risk,” that he is scheduled to present next month at a Federal Reserve conference.

But regulators, eager to avoid being blamed for missteps in oversight, also have an interest in the status quo, Mr. Kane argues.  “As in a long-running poker game in which one player (here, the taxpayer) is a perennial and relatively clueless loser,” he writes, “other players see little reason to disturb the equilibrium.”

At Forbes, Robert Lenzner focused on the human failings responsible for the bad behavior of the big banks with his emphasis on the notion that “a fish stinks from the head”:

No well-intentioned reform bill that will pass Congress can prevent the mind-blowing stupidity, hubris and denial utilized by the big fish of Wall Street from stinking from the head.

*   *   *

Transparency won’t help if the Obama plan does not absolutely require all derivatives to be registered at the Securities and Exchange Commission.  It’s an invitation for abuse as five major market making banks like JPMorgan Chase account for 95% of all derivatives transactions and a very large share of their profits.  We haven’t seen evidence that they police themselves satisfactorily.

Derivatives expert Janet Tavakoli recently expressed her disgust over the disingenuousness of the current version of this legislation:

Our proposed “financial reform” bill is a sham, and the health of our society and our economy is at stake.

Ms. Tavakoli referred to the recent Huffington Post article by Dan Froomkin, which highlighted the criticism of the financial reform legislation provided by Professor William Black (the former prosecutor from the Savings and Loan crisis, whose execution was called for by Charles Keating).  Froomkin embraced the logic of economist James Galbraith, who emphasized that rather than relying on the expertise of economists to shape financial reform, we should be looking to the assistance of criminologists.  William Black reinforced this idea:

Criminologists, Black said, are trained to identify the environments that produce epidemics of fraud — and in the case of the financial crisis, the culprit is obvious.

“We’re looking at incentive structures,” he told HuffPost.  “Not people suddenly becoming evil.  Not people suddenly becoming crazy.  But people reacting to perverse incentive structures.”

CEOs can’t send out a memo telling their front-line professionals to commit fraud, “but you can send the same message with your compensations system, and you can do it without going to jail,” Black said.

Criminologists ask “fundamentally different types of question” than the ones being asked.

Back at The New York Times, Frank Rich provided us with a rare example of mainstream media outrage over the lack of interest in prosecuting the fraudsters responsible for the financial disaster that put eight million people out of work:

That no one at Lehman Brothers has yet been held liable for its Enronesque bookkeeping deceit is appalling.  That we still haven’t seen the e-mail and documents that would illuminate A.I.G.’s machinations with Goldman and the rest of its counterparties amounts to a cover-up.  That investigative journalists have consistently been way ahead of the authorities, the S.E.C. included, in uncovering Wall Street’s foul play is a scandal.  If this culture remains in place, the whole crisis will have gone to waste.

Unfortunately, the likelihood that any significant financial reform will be enacted as a result of the financial crisis is about the same as the likelihood that we will see anyone doing a “perp walk” for the fraudulent behavior that caused the meltdown.  Don’t expect serious reform and don’t expect justice.



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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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Financial Crisis Inquiry Disappointment

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April 15, 2010

The Financial Crisis Inquiry Commission (FCIC) has been widely criticized for its lame efforts at investigating the causes of the financial crisis.  As I pointed out on January 11, a number of commentators had been expressing doubt concerning what the FCIC could accomplish before the commission held its first hearing.  At this point — just three months later — we are already hearing the question of whether it might be “time to pull the plug on the FCIC”.   Writing for the Center for Media and Democracy’s PRWatch.org website, Mary Bottari posed that question as the title to her critical piece, documenting the commission’s “lackluster performance”:

The FCIC is a 10-person panel assembled to report on the meltdown to President Obama later this year.  The New York Times reported last week what was becoming increasingly obvious: the commission was in shambles.  The commission waited eight months before having its first hearing.  A top investigator resigned due to delays in hiring staff, no subpoenas have been issued and partisan infighting means few new documents have been released that would aid reporters in piecing together the crime scene, even if  FCIC investigators are not up to the task.  Worse, it seems like the majority of staff  have been borrowed from the complicit Federal Reserve.

These problems were on full display in last week’s hearings.  The three days of hearings were marked by some heat, but little light.

The FCIC’s failure to issue any subpoenas became a major point of criticism by Eliot Spitzer, who had this to say in a recent posting for Slate :

The Financial Crisis Inquiry Commission has so far been a waste.  Some momentary theater has been provided by the witnesses who have tried to excuse, explain, or occasionally admit their role in the cataclysm of the past two years.  While this has ginned up some additional public outrage, it hasn’t deepened our knowledge about what critical players knew or did.  There is a simple reason for this:  The commission has not issued a single subpoena.  Any investigator will tell you that you must get the documentary evidence before you examine the witnesses.  The evidence is waiting to be seized from the Fed, AIG, Goldman Sachs, and on down the line.  Yet not one subpoena.

Rather than accept Robert Rubin’s simple disclaimers about Citigroup, why hasn’t the FCIC combed through the actual communications among the board, the executive committee, the audit committee, and the risk-management committee?  Why hasn’t the FCIC collected AIG’s e-mails with the Fed and Goldman Sachs?  Unless the subpoenas are issued, we will lose the chance to make the record.

As Binyamin Appelbaum pointed out in The Washington Post back on January 8, if a financial reform bill is eventually passed, it will likely be signed into law before the mid-term elections in November – one month before the FCIC is required to publish its findings.  As a result, there is a serious question as to whether the commission’s efforts will contribute anything to financial reform legislation.  Given the FCIC’s unwillingness to exercise its subpoena power, we are faced with the question of why the commission should even bother wasting its time and the taxpayers’ money on an irrelevant, ineffective exercise.

Although Mary Bottari’s essay discussed the possibility that the FCIC might still “get its act together”, the cynicism expressed by Eliot Spitzer provided a much more realistic assessment of the situation:

Americans have been betrayed by Washington over financial reform.  Our leaders have failed to get the evidence, failed to push back when clearly inadequate explanations were provided, and failed to explore the structural reforms that will work.  Pretend tears will drip from bankers’ eyes after the consumer protection agency is created.  Then their wolfish teeth will slowly break into a grin, the pure delight that Washington has failed to do anything meaningful to restructure the banking sector.

Just when it was beginning to appear as though we might actually see some meaningful financial reform find its way into law, we have been reminded that Washington has its own ways – which benefit the American public only by rare coincidence.




Financial Reform Might Actually Happen

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April 12, 2010

The long-overdue need for financial reform is finally getting some serious attention in Washington.  As banking lobbyists continue to grease palms in the Senate, we are beginning to hear a number of novel ideas from some clever commentators, focused on preventing another financial crisis.

On April 9, John Mauldin published a thought-provoking essay entitled, “Reform We Can Believe In”.  At one point in the piece, Mauldin considered the question that has been hanging over our heads for the past eighteen months:

What happens if we do nothing?

What happens when we have the next credit crisis, when a major sovereign government defaults, as I think will happen?  It will be a body blow to many banks, especially in Europe.  Once again, we could have banks worried about lending to each other or taking letters of credit, which would be a disaster for world trade and the recovery we are now in.

That we (and Europe and Britain) have taken so long to enact real reform has the potential to really put the world at risk.  In the next crisis, we will not have the tools available to stem the tide that we did the last time.  Rates are already low.  Do you think we could pass another TARP?  The Fed’s balance sheet is already bloated.  It could get much worse unless we get financial reforms that have some bite.

All this debating about a consumer protection agency and where it should be and all the other trivia is wasting time.  Fix the big things. Credit default swaps. Too big to fail.  Leverage. Then worry about the details.

Although I left out Mauldin’s suggestion to “leave the Fed alone” from that last paragraph, his essay contains a fantastic explanation of how the Federal Reserve System is organized.  Best of all, Mauldin spent plenty of time reflecting on Milton Friedman’s suggestion that we program a computer to set monetary policy, instead of leaving that authority with the Fed:

Let me be clear.  There are a lot of things not to like about the Federal Reserve System.  I think it was Milton Friedman who said we would be better off with a computer determining monetary policy.  A quote from an interview with him is instructive.  When asked “Do you still think it would be a good idea to have a computer run monetary policy?” he answered:

“Yes.  Of course it depends very much on how the computer is programmed.  I am not saying that any computer program would do.  In speaking of that, I have had in mind the idea that a computer would produce, for example, a constant rate of growth in the quantity of money as defined, let us say, by M2, something like 3% to 5% per year.  There are certainly occasions in which discretionary changes in policy guided by a wise and talented manager of monetary policy would do better than the fixed rate, but they would be rare.

“In any event, the computer program would certainly prevent any major disasters either way, any major inflation or any major depressions.  One of the great defects of our kind of monetary system is that its performance depends so much on the quality of the people who are put in charge.  We have seen that in the history of our own Federal Reserve System.

Another perspective on financial reform came from Jim McTague in the April 12 edition of Barron’s.  He began with the remark that both the House and Senate reform bills lack adequate measures for “efficient and intelligent policing”.  Nevertheless, the solution he embraced was simple:

The aptly named Richard Vigilante, who recently co-wrote a book called Panic with Minneapolis-based hedge-fund legend Andrew Redleaf, suggests this approach:  Force all firms managing other people’s money to publish their investment positions in detail before the market opens; this would include hedge funds.  Then, the short sellers could punish ineptness before it spreads by betting heavily against a particular institution’s stupid decisions.

“Bankers would hate it.  It’s their worst nightmare,” says Vigilante, whom I met with at Firehook bakery on Washington’s Farragut Square.  If the system had been in place in 2006, short sellers would have stamped out the smoldering subprime mania before it had a chance to spread, he asserts.

His suggestion is both brilliant and a model of simplicity — it could protect consumers against all kinds of risky financial products — but it will never become reality.

Bankers would scream about the need to protect their proprietary-trading information.  And, as was the case with health-insurance “reform,” Congress is bent on ramming a bill, no matter how flawed, through the legislative sausage works in order to mollify an uncommonly angry electorate before Nov. 2.  To entertain new ideas at this juncture, even good ones, would upset the ambitious timetable.

Like health care, the new financial regulatory regime is built atop the cracked masonry of the old one.  The same flatfoots who were on patrol when the subprime caper went down will be given larger beats to walk.  They will be overseen by a brain trust, a Council of Regulators, culled from their ranks, who, like chemical sniffers, would seek to uncover systemic threats to the volatile financial system.  In fact, COR is the core of the whole scheme.

The proposal for a Council of Regulators has drawn a good deal of criticism, primarily because it would be chaired by the Treasury Secretary.  Matthew Bishop and Michael Green, authors of The Road From Ruin, had this to say about a Council of Regulators in a recent Huffington Post piece:

Indeed, with the Treasury Secretary in the chair, would this council really face down the political leaders and try to stop an emerging bubble spreading a feelgood factor across the nation (as bubbles do, before they burst)?  Even in his pomp Alan Greenspan knew that a Fed chairman couldn’t risk being too gloomy about the economy and keep his job. What chance then of a Treasury Secretary, a cabinet member, being so bold?

Rather than another layer on top of the dysfunctional existing regulatory system, America needs to sweep away its absurd proliferation of regulators and replace them with a powerful super regulator, independent of day-to-day politics and empowered to do the job properly.

Regardless of what the final product will include – one thing is becoming increasingly likely:  Some semblance of financial reform legislation will eventually become enacted.  It won’t be perfect but anything will be better than what we have now.  (Well, almost anything  .  .  .)



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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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Getting Cozy

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April 1, 2010

This week’s decision by the United States Supreme Court, in the case of Jones v.Harris Associates received a good deal of attention because it increased hopes of a cut in the fees mutual funds charge to individual investors.  The plaintiffs, Jerry Jones, Mary Jones and Arline Winerman, sued Harris Associates (which runs or “advises” the Oakmark mutual funds) for violating the Investment Company Act, by charging excessive fees.  Harris was charging individual investors a .88 percent (88 basis points) management fee, compared to the 45-bps fee charged to its institutional clients.

In his article about the Jones v. Harris case, David Savage of the Los Angeles Times made a point that struck a chord with me:

Pay scales in the mutual fund industry, like those in banking and investment firms, are not strictly regulated by the government, and as the Wall Street collapse revealed, investment advisors and bankers sometimes can earn huge fees while losing money for their shareholders.

In 1970, however, Congress said mutual funds must operate with an independent board of directors.  And it said the investment advisors for the funds have a “fiduciary duty,” or a duty of trust, to the investors when setting fees for their services.  The law also allowed suits against those suspected of violating this duty.

But investors have rarely won such claims.  In Tuesday’s decision, the Supreme Court gave new life to the law, ruling that investment advisors could be sued for charging excessive fees.

But the court’s opinion also said such suits should fail unless there was evidence that advisors hid information from the board or that their fees were “so disproportionately large” as to suggest a cozy deal between the advisors and the supposedly independent board.

The lousy job that boards of directors do in protecting the investors they supposedly represent has become a big issue since the financial crisis, as Mr. Savage explained.  Think about it:  How could the boards of directors for those too-big-to-fail institutions allow the payouts of obscene bonuses to the very people who devastated our economy and nearly destroyed (or may yet destroy) our financial system?  The directors have a duty to the shareholders to make sure those investors obtain a decent dividend when the company does well.  If the company does well only because of a government bailout, despite inept management by the executives, who should benefit – the execs or the shareholders?

Michael Brush wrote an interesting essay concerning bad corporate boards for MSN Money on Wednesday.  His opining point was another reminder of how the financial crisis was facilitated by cozy relationships with bank boards:

Here’s a key take-away from the financial crisis that devastated our economy:   Bad boards of directors played a big role in the mess.

Because bank boards were too close to the executives they were supposed to police, they did a lousy job of spotting excessive risk.  They allowed short-term pay incentives such as huge options grants that encouraged bankers to roll the dice.

Michael Brush contacted The Corporate Library which used its Board Analyst screener to come up with a list of the five worst corporate boards.  Here is how he explained that research:

The ratings are based on problems that can compromise boards, including:

  • Allowing directors to do too much business with the companies they are supposed to oversee.
  • Letting the CEO chair the board, which is supposed to oversee the CEO.
  • Overpaying board members and keeping them on too long.
  • Allowing directors to miss too many meetings to do an effective job.

These and other red flags signal that a board is entrenched — too close to management to do its job of overseeing the people in the corner offices.

*   *   *

The big problem with bad boards is that they’re unlikely to ask CEOs tough questions, act swiftly when it is time to replace a CEO or tighten the reins on pay and perks.  And bad boards hurt shareholders.  Several studies have indicated that the stocks of companies with weak boards underperform.

I won’t spoil the surprise for you by identifying the companies with the bad boards.  If you want that information you will have to read the full piece.  Besides — you should read it anyway.

All of this raises the question (once again) of whether we will see any changes result in the aftermath of the financial crisis that will help protect the “little people” or the not-so-little “investor class”.   I’m not betting on it.



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Building A Consensus For Survival

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March 29, 2010

In my last posting, I focused on the fantastic discourse in favor of financial reform presented by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, in a speech before the U.S. Chamber of Commerce.  In addition to Hoenig’s speech, last week brought us a number of excellent arguments for the cause that is so bitterly opposed by Wall Street lobbyists.  On the same day that Thomas Hoenig delivered his great speech to the U.S. Chamber of Commerce, Deputy Treasury Secretary Neal Wolin also addressed that institution to argue in favor of financial reform.  I enjoyed the fact that he rubbed this in their faces:

That is why it is so puzzling that, despite the urgent and undeniable need for reform, the Chamber of Commerce has launched a $3 million advertising campaign against it.  That campaign is not designed to improve the House and Senate bills.  It is designed to defeat them.  It is designed to delay reform until the memory of the crisis fades and the political will for change dies out.

The Chamber’s campaign comes on top of the $1.4 million per day already being spent on lobbying and campaign contributions by big banks and Wall Street financial firms.  There are four financial lobbyists for every member of Congress.

Wolin’s presentation was yet another signal from the Treasury Department that inspired economist Simon Johnson to begin feeling optimistic about the possibility that some meaningful degree of financial reform might actually take place:

Against all the odds, a glimmer of hope for real financial reform begins to shine through.  It’s not that anything definite has happened — in fact most of the recent Senate details are not encouraging – but rather that the broader political calculus has shifted in the right direction.

Instead of seeing the big banks as inviolable, top people in Obama administration are beginning to see the advantage of taking them on — at least on the issue of consumer protection.  Even Tim Geithner derided the banks recently as,

“those who told us all they were the masters of noble             financial innovation and sophisticated risk management.”

Yep.  That was our old pal and former New York Fed President, “Turbo” Tim Geithner, making the case for financial reform before the American Enterprise Institute.  (You remember them — the outfit that fired David Frum for speaking out against Fox News and the rest of the “conservative entertainment industry”.)  Treasury Secretary Geithner made his pitch for reform by reminding his conservative audience that longstanding advocates of the “efficient market hypothesis” had come on board in favor of financial reform:

Now, the recognition that markets failed and that the necessary solution involves reform; that it requires rules enforced by government is not a partisan or political judgment.  It is a conclusion reached by liberals and by conservative skeptics of regulation.

Judge Richard Posner, a leader in the conservative Chicago School of economics, wrote last year, that “we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.”

And consider Alan Greenspan, a skeptic of the benefits of regulation, who recently said, “inhibiting irrational behavior when it can be identified, through regulation,   . . .   could be stabilizing.”

No wonder Simon Johnson is feeling so upbeat!  The administration is actually making a serious attempt at doing what needs to be done to get this accomplished.

Meanwhile, The New York Times had run a superb article by David Leonhardt just as Geithner was about to address the AEI.  Leonhardt’s essay, “Heading Off the Next Financial Crisis” is a thorough analysis, providing historical background and covering every angle on what needs to be done to clean up the mess that got us where we are today — and to prevent it from happening again.  Here are some snippets from the first page that had me hooked right away:

It was a maddening story line:  the government helped the banks get rich by looking the other way during good times and saved them from collapse during bad times.  Just as an oil company can profit from pollution, Wall Street profited from weak regulation, at the expense of society.

*   *   *

In a way, this issue is more about human nature than about politics.  By definition, the next period of financial excess will appear to have recent history on its side.

*   *   *

One way to deal with regulator fallibility is to implement clear, sweeping rules that limit people’s ability to persuade themselves that the next bubble is different — upfront capital requirements, for example, that banks cannot alter.  Thus far, the White House, the Fed and Congress have mostly steered clear of such rules.

Congratulations to David Leonhardt for putting that great piece together.  As more commentators continue to advance such astute, sensible appeals to plug the leaks in our sinking financial system, there is a greater likelihood that our lawmakers will realize that the economic risk of doing nothing far exceeds the amounts of money in those envelopes from the lobbyists.



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The Best Argument For Financial Reform

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March 26, 2010

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, spoke out in favor of financial reform on Wednesday in a speech before the U.S. Chamber of Commerce.  The shocking aspect of Hoenig’s speech is that it comes from the mouth of a member of the Federal Reserve’s Open Market Committee (FOMC) which sets economic policy.  Beyond that, Hoenig brutally criticized what has been done so far to tilt the playing field in favor of the megabanks, at the expense of smaller banks.  Here are some choice bits from what should be mandatory reading for everyone in Congress:

As a nation, we have violated the central tenants of any successful system.  We have seen the formation of a powerful group of financial firms.  We have inadvertently granted them implied guarantees and favors, and we have suffered the consequences.  We must correct these violations.  We must reinvigorate fair competition within our system in a culture of business ethics that operates under the rule of law.  When we do this, we will not eliminate the small businesses’ need for capital, but we will make access to capital once again earned, as it should be.

*   *   *

The fact is that Main Street will not prosper without a healthy financial system.  We will not have a healthy financial system now or in the future without making fundamental changes that reverse the wrong-headed incentives, change behavior and reinforce the structure of our financial system.  These changes must be made so that the largest firms no longer have the incentive to take too much risk and gain a competitive funding advantage over smaller ones.  Credit must be allocated efficiently and equitably based on prospective economic value.  Without these changes, this crisis will be remembered only in textbooks and then we will go through it all again.

Hoenig’s speech comes at a time when the Senate is considering a watered-down version of financial reform that has been widely criticized.  Economist Simon Johnson pointed out how any approach based on U.S. authority alone to “resolve” or break up systemically dangerous banks would be doomed because “there is no cross-border agreement on resolution process and procedure — and no prospect of the same in sight”.

Blogger Mike Konczal expressed his disappointment with what has become of the Financial Reform Bill as it has been dragged through the legislative process:

It’s funny, I know what a good financial reform bill becoming a bad financial reform bill looks like through this process.  I’ve seen bribes and more bribes and last-minute giveaway changes.

The notion that bribery has been an obstacle to financial reform became a central theme of Karl Denninger’s enthusiastic reaction to Hoenig’s speech:

All in all it’s nice to see Thomas Hoenig wake up.  Now let’s see if we can get CONgress to stop opening the bribe envelopes, er, ignore the campaign contributions for a sufficient period of time to actually fix this mess, forcing those “big banks” to get that leverage ratio down to where it belongs, along with marking their assets to the market.

Thomas Hoenig provided exactly the type of leadership needed and at exactly the right time to give a boost to serious financial reform.  We can only hope that there will be enough responsible, ethical people in the Senate to incorporate Hoenig’s suggestions into the Financial Reform Bill.  If only  . . .



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