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Get Ready for the Next Financial Crisis

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It was almost one year ago when Bloomberg News reported on these remarks by Mark Mobius, executive chairman of Templeton Asset Management’s emerging markets group:

“There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis,” Mobius said at the Foreign Correspondents’ Club of Japan inTokyotoday in response to a question about price swings. “Are the derivatives regulated?  No.  Are you still getting growth in derivatives?  Yes.”

I have frequently complained about the failed attempt at financial reform, known as the Dodd-Frank Act.  Two years ago, I wrote a piece entitled, “Financial Reform Bill Exposed As Hoax” wherein I expressed my outrage that the financial reform effort had become a charade.  The final product resulting from all of the grandstanding and backroom deals – the Dodd–Frank Act – had become nothing more than a hoax on the American public.  My essay included the reactions of five commentators, who were similarly dismayed.  I concluded the posting with this remark:

The bill that is supposed to save us from another financial crisis does nothing to accomplish that objective.  Once this 2,000-page farce is signed into law, watch for the reactions.  It will be interesting to sort out the clear-thinkers from the Kool-Aid drinkers.

During the past few days, there has been a chorus of commentary calling for a renewed effort toward financial reform.  We have seen a torrent of reports on the misadventures of The London Whale at JP Morgan Chase, whose outrageous derivatives wager has cost the firm uncounted billions.  By the time this deal is unwound, the originally-reported loss of $2 billion will likely be dwarfed.

Former Secretary of Labor, Robert Reich, has made a hobby of writing blog postings about “what President Obama needs to do”.  Of course, President Obama never follows Professor Reich’s recommendations, which might explain why Mitt Romney has been overtaking Obama in the opinion polls.  On May 16, Professor Reich was downright critical of the President, comparing him to the dog in a short story by Sir Arthur Conan Doyle involving Sherlock Holmes, Silver Blaze.  The President’s feeble remarks about JPMorgan’s latest derivatives fiasco overlooked the responsibility of Jamie Dimon – obviously annoying Professor Reich, who shared this reaction:

Not a word about Jamie Dimon’s tireless campaign to eviscerate the Dodd-Frank financial reform bill; his loud and repeated charge that the Street’s near meltdown in 2008 didn’t warrant more financial regulation; his leadership of Wall Street’s brazen lobbying campaign to delay the Volcker Rule under Dodd-Frank, which is still delayed; and his efforts to make that rule meaningless by widening a loophole allowing banks to use commercial deposits to “hedge” (that is, make offsetting bets) their derivative trades.

Nor any mention Dimon’s outrageous flaunting of Dodd-Frank and of the Volcker Rule by setting up a special division in the bank to make huge (and hugely profitable, when the bets paid off) derivative trades disguised as hedges.

Nor Dimon’s dual role as both chairman and CEO of JPMorgan (frowned on my experts in corporate governance) for which he collected a whopping $23 million this year, and $23 million in 2010 and 2011 in addition to a $17 million bonus.

Even if Obama didn’t want to criticize Dimon, at the very least he could have used the occasion to come out squarely in favor of tougher financial regulation.  It’s the perfect time for him to call for resurrecting the Glass-Steagall Act, of which the Volcker Rule – with its giant loophole for hedges – is a pale and inadequate substitute.

And for breaking up the biggest banks and setting a cap on their size, as the Dallas branch of the Federal Reserve recommended several weeks ago.

This was Professor Reich’s second consecutive reference within a week to The Dallas Fed’s Annual Report, which featured an essay by Harvey Rosenblum, the head of the Dallas Fed’s Research Department and the former president of the National Association for Business Economics.  Rosenblum’s essay provided an historical analysis of the events leading up to the 2008 financial crisis and the regulatory efforts which resulted from that catastrophe – particularly the Dodd-Frank Act.  Beyond that, Rosenblum emphasized why those “too-big-to-fail” (TBTF) banks have actually grown since the enactment of Dodd-Frank:

The TBTF survivors of the financial crisis look a lot like they did in 2008.  They maintain corporate cultures based on the short-term incentives of fees and bonuses derived from increased oligopoly power.  They remain difficult to control because they have the lawyers and the money to resist the pressures of federal regulation.  Just as important, their significant presence in dozens of states confers enormous political clout in their quest to refocus banking statutes and regulatory enforcement to their advantage.

Last year, former Kansas City Fed-head, Thomas Hoenig discussed the problems created by the TBTFs, which he characterized as “systemically important financial institutions” – or “SIFIs”:

…  I suggest that the problem with SIFIs is they are fundamentally inconsistent with capitalism.  They are inherently destabilizing to global markets and detrimental to world growth.  So long as the concept of a SIFI exists, and there are institutions so powerful and considered so important that they require special support and different rules, the future of capitalism is at risk and our market economy is in peril.

Although the huge derivatives loss by JPMorgan Chase has motivated a number of commentators to issue warnings about the risk of another financial crisis, there had been plenty of admonitions emphasizing the risks of the next financial meltdown, which were published long before the London Whale was beached.  Back in January, G. Timothy Haight wrote an inspiring piece for the pro-Republican Orange County Register, criticizing the failure of our government to address the systemic risk which brought about the catastrophe of 2008:

In response to widespread criticism associated with the financial collapse, Congress has enacted a number of reforms aimed at curbing abuses at financial institutions.  Legislation, such as the Dodd-Frank and Consumer Protection Act, was trumpeted as ensuring that another financial meltdown would be avoided.  Such reactionary regulation was certain to pacify U.S. taxpayers.

Unfortunately, legislation enacted does not solve the fundamental problem.  It simply provides cover for those who were asleep at the wheel, while ignoring the underlying cause of the crisis.

More than three years after the calamity, have we solved the dilemma we found ourselves in late 2008?  Can we rest assured that a future bailout will not occur?  Are financial institutions no longer “too big to fail?”

Regrettably, the answer, in each case, is a resounding no.

Last month, Michael T. Snyder of The Economic Collapse blog wrote an essay for the Seeking Alpha website, enumerating the 22 Red Flags Indicating Serious Doom Is Coming for Global Financial Markets.  Of particular interest was red flag #22:

The 9 largest U.S. banks have a total of 228.72 trillion dollars of exposure to derivatives.  That is approximately 3 times the size of the entire global economy.  It is a financial bubble so immense in size that it is nearly impossible to fully comprehend how large it is.

The multi-billion dollar derivatives loss by JPMorgan Chase demonstrates that the sham “financial reform” cannot prevent another financial crisis.  The banks assume that there will be more taxpayer-funded bailouts available, when the inevitable train wreck occurs.  The Federal Reserve will be expected to provide another round of quantitative easing to keep everyone happy.  As a result, nothing will be done to strengthen financial reform as a result of this episode.  The megabanks were able to survive the storm of indignation in the wake of the 2008 crisis and they will be able ride-out the current wave of public outrage.

As Election Day approaches, Team Obama is afraid that the voters will wake up to the fact that the administration itself  is to blame for sabotaging financial reform.  They are hoping that the public won’t be reminded that two years ago, Simon Johnson (former chief economist of the IMF) wrote an essay entitled, “Creating the Next Crisis” in which he provided this warning:

On the critical dimension of excessive bank size and what it implies for systemic risk, there was a concerted effort by Senators Ted Kaufman and Sherrod Brown to impose a size cap on the largest banks – very much in accordance with the spirit of the original “Volcker Rule” proposed in January 2010 by Obama himself.

In an almost unbelievable volte face, for reasons that remain somewhat mysterious, Obama’s administration itself shot down this approach.  “If enacted, Brown-Kaufman would have broken up the six biggest banks inAmerica,” a senior Treasury official said.  “If we’d been for it, it probably would have happened.  But we weren’t, so it didn’t.”

Whether the world economy grows now at 4% or 5% matters, but it does not much affect our medium-term prospects. The US financial sector received an unconditional bailout – and is not now facing any kind of meaningful re-regulation.  We are setting ourselves up, without question, for another boom based on excessive and reckless risk-taking at the heart of the world’s financial system.  This can end only one way:  badly.

The public can forget a good deal of information in two years.  They need to be reminded about those early reactions to the Obama administration’s subversion of financial reform.  At her Naked Capitalism website, Yves Smith served up some negative opinions concerning the bill, along with her own cutting commentary in June of 2010:

I want the word “reform” back.  Between health care “reform” and financial services “reform,” Obama, his operatives, and media cheerleaders are trying to depict both initiatives as being far more salutary and far-reaching than they are.  This abuse of language is yet another case of the Obama Administration using branding to cover up substantive shortcomings.  In the short run it might fool quite a few people, just as BP’s efforts to position itself as an environmentally responsible company did.

*   *   *

So what does the bill accomplish?  It inconveniences banks around the margin while failing to reduce the odds of a recurrence of a major financial crisis.

On May 17, Noam Scheiber explained why the White House is ”sweating” the JPMorgan controversy:

In particular, the transaction appears to have been a type of proprietary trade – which is to say, a trade that a bank undertakes to make money for itself, not its clients.  And these trades were supposed to have been outlawed by the “Volcker Rule” provision of Obama’s financial reform law, at least at federally-backed banks like JP Morgan.  The administration is naturally worried that, having touted the law as an end to the financial shenanigans that brought us the 2008 crisis, it will look feckless instead.

*   *   *

But it turns out that there’s an additional twist here.  The concern for the White House isn’t just that the law could look weak, making it a less than compelling selling point for Obama’s re-election campaign.  It’s that the administration could be blamed for the weakness.  It’s one thing if you fought for a tough law and didn’t entirely succeed.  It’s quite another thing if it starts to look like you undermined the law behind the scenes.  In that case, the administration could look duplicitous, not merely ineffectual.  And that’s the narrative you see the administration trying to preempt   .   .   .

When the next financial crisis begins, be sure to credit President Obama as the Facilitator-In-Chief.


 

Too Important To Ignore

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On March 21, the Federal Reserve Bank of Dallas released a fantastic document:  its 2011 Annual Report, featuring an essay entitled, “Choosing the Road to Prosperity – Why We Must End Too Big to Fail – Now”.  The essay was written by Harvey Rosenblum, the head of the Dallas Fed’s Research Department and the former president of the National Association for Business Economics.  Rosenblum’s essay provided an historical analysis of the events leading up to the 2008 financial crisis and the regulatory efforts which resulted from that catastrophe – particularly the Dodd-Frank Act.

While reading Harvey Rosenblum’s essay, I was constantly reminded of the creepy “JOBS Act” which is on its way to President Obama’s desk.  Simon Johnson (former chief economist for the International Monetary Fund) recently explained why the JOBS Act poses the same threat as the deregulatory measures which helped cause the financial crisis:

With the so-called JOBS bill, on which the Senate is due to vote Tuesday, Congress is about to make the same kind of mistake again – this time abandoning much of the 1930s-era securities legislation that both served investors well and helped make the US one of the best places in the world to raise capital.  We find ourselves again on a bipartisan route to disaster.

*   *   *

The idea behind the JOBS bill is that our existing securities laws – requiring a great deal of disclosure – are significantly holding back the economy.

The bill, HR3606, received bipartisan support in the House (only 23  Democrats voted against).  The bill’s title is JumpStart Our Business Startup Act, a clever slogan – but also a complete misrepresentation.

The bill’s proponents point out that Initial Public Offerings (IPOs) of stock are way down.  That is true – but that is also exactly what you should expect when the economy teeters on the brink of an economic depression and then struggles to recover because households’ still have a great deal of debt.

*   *   *

Professor John Coates hit the nail on the head:

“While the various proposals being considered have been characterized as promoting jobs and economic growth by reducing regulatory burdens and costs, it is better to understand them as changing, in similar ways, the balance that existing securities laws and regulations have struck between the transaction costs of raising capital, on the one hand, and the combined costs of fraud risk and asymmetric and unverifiable information, on the other hand.” (See p.3 of this December 2011 testimony.)

In other words, you will be ripped off more.  Knowing this, any smart investor will want to be better compensated for investing in a particular firm – this raises, not lowers, the cost of capital.  The effect on job creation is likely to be negative, not positive.

Simon Johnson’s last paragraph reminded me of a passage from Harvey Rosenblum’s Dallas Fed essay, wherein he was discussing why the economic recovery from the financial crisis has been so sluggish:

Similarly, the contributions to recovery from securities markets and asset prices and wealth have been weaker than expected.  A prime reason is that burned investors demand higher-than-normal compensation for investing in private-sector projects. They remain uncertain about whether the financial system has been fixed and whether an economic recovery is sustainable.

To repeat what Simon Johnson said, combined with the above-quoted paragraph:  the demand by “burned investors” for “higher-than-normal compensation for investing in private-sector projects” raises, not lowers, the cost of capital.  How quickly we forget the lessons of the financial crisis!

The Dallas Fed’s Annual Report began with an introductory letter from its president, Richard W. Fisher.  Fisher noted that while “memory fades with the passage of time” it is important to recall the position in which the “too-big-to fail” banks placed our economy, thus leading Congress to pass into law the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank).  Although Harvey Rosenblum’s essay was primarily focused on the Dodd-Frank Act’s efforts to address the systemic risk posed by the existence of those “too-big-to-fail” (TBTF) banks, other measures from Dodd-Frank were mentioned.  More important is the fact that the TBTFs have actually grown since the enactment of Dodd-Frank.  Beyond that, Rosenblum emphasized why this has happened:

The TBTF survivors of the financial crisis look a lot like they did in 2008.  They maintain corporate cultures based on the short-term incentives of fees and bonuses derived from increased oligopoly power.  They remain difficult to control because they have the lawyers and the money to resist the pressures of federal regulation.  Just as important, their significant presence in dozens of states confers enormous political clout in their quest to refocus banking statutes and regulatory enforcement to their advantage.

The ability of the financial sector “to resist the pressures of federal regulation” also happens to be the primary reason for the perverse effort toward de-regulation, known as the JOBS Act.  At the Seeking Alpha website, Felix Salmon reflected on the venality which is driving this bill through the legislative process:

There’s no good reason at all for this:  it’s basically a way for unpopular incumbent lawmakers who voted for Dodd-Frank to try to weasel their way back into the big banks’ good graces and thereby open a campaign-finance spigot they desperately need.

I don’t fully understand the political dynamics here.  A bill which was essentially drafted by a small group of bankers and financiers has managed to get itself widespread bipartisan support, even as it rolls back decades of investor protections.  That wouldn’t have been possible a couple of years ago, and I’m unclear (about) what has changed.  But one thing is coming through loud and clear:  anybody looking to Congress to be helpful in the fight to have effective regulation of financial institutions, is going to be very disappointed.  Much more likely is that Congress will be actively unhelpful, and will do whatever the financial industry wants in terms of hobbling regulators and deregulating as much activity as it possibly can.  Dodd-Frank, it seems, was a brief aberration.  Now, we’re back to business as usual, and a captured Congress.

The next financial crisis can’t be too far down the road   .   .   .