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.
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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.”
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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.
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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.
Too Cute By Half
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 :
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.