TheCenterLane.com

September 24, 2009

Last year’s financial crisis and our current economic crisis have exposed some pretty ugly things to an unsuspecting public.  As news reporters dig and as witnesses are called to testify, these investigations are turning over a very large rock, revealing all the colonies of maggots and fungus infestations, just below ground level, out of our usual view.  The voters are learning more about the sleaziness that takes place on Wall Street and in the halls of Congress.  Hopefully, they will become motivated to demand some changes.

A recent report by American Public Media’s Steve Henn revealed how the law prohibiting “insider trading” (i.e. acting on confidential corporate information when making a transaction involving that company’s publicly-traded stock) does not apply to members of Congress.  Remember how Martha Stewart went to prison?  Well, if she had been representing Connecticut in Congress, she might have been able to interpose the defense that she was inspired to sell her ImClone stock based on information she acquired in the exercise of her official duties.  Mr. Henn’s report discussed the investment transactions made by some Senators after having been informed by former Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke, that our financial system was on the verge of a meltdown.  After quoting GOP House Minority Leader John Boehner’s public acknowledgement last September that:

We clearly have an unprecedented crisis in our financial system.   .   .   .

On behalf of the American people our job is to put our partisan differences aside and to work together to help solve this crisis.

Mr. Henn proceeded to explain how swift Senatorial action resulted in a bipartisan exercise of greed:

The next day, according to personal financial disclosures, Boehner cashed out of a fund designed to profit from inflation.  Since he sold, it’s lost more than half its value.

Sen. Dick Durbin, an Illinois Democrat, who was also at that meeting sold more than $40,000 in mutual funds and reinvested it all with Warren Buffett.

Durbin said like millions of others he was worried about his retirement. Boehner says his stock broker acted alone without even talking to him.  Both lawmakers say they didn’t benefit from any special tips.

But over time members of Congress do much better than the rest of us when playing the stock market.

*   *   *

The value of information that flows from the inner workings of Washington isn’t lost on Wall Street professionals.

Michael Bagley is a former congressional staffer who now runs the OSINT Group. Bagley sells access and research. His clients are hedge funds, and he makes it his business to mine Congress and the rest of Washington for tips.

MICHAEL Bagley: The power center of finance has moved from Wall Street to Washington.

His firm is just one recent entry into Washington’s newest growth industry.

CRAIG HOLMAN: It’s called political intelligence.

Craig Holman is at Public Citizen, a consumer watchdog.  Holman believes lobbyists shouldn’t be allowed to sell tips to hedge funds and members of Congress shouldn’t trade on non-public information.  But right now it’s legal.

HOLMAN: It’s absolutely incredible, but the Securities and Exchange Act does not apply to members of Congress, congressional staff or even lobbyists.

That law bans corporate insiders, from executives to their bankers and lawyers, from trading on inside information.  But it doesn’t apply to political intelligence.  That makes this business lucrative.  Bagley says firms can charge hedge funds $25,000 a month just to follow a hot issue.

BAGLEY: So information is a commodity in Washington.

Inside information on dozens of issues, from bank capitol requirements to new student loan rules, can move markets.  Consumer advocate Craig Holman is backing a bill called the STOCK Act.  Introduced in the House, it would force political-intelligence firms to disclose their clients and it would ban lawmakers, staffers, and lobbyists from profiting on non-public knowledge.

Mr. Henn’s report went on to raise concern over the fact that there is nothing to stop members of Congress from acting on such information to the detriment of their constituents in favor of their own portfolios.

In his prepared testimony before the House Financial Services Committee this morning, former Federal Reserve Chair Paul Volcker made this observation:

I understand, and share, concern that the financial crisis has revealed weaknesses in our regulatory and supervisory agencies as well as in the activities of private financial institutions.  There has been criticism of the Federal Reserve itself, and even proposals to remove responsibilities other than monetary policy, strictly defined, from the Fed.

Mr. Volcker discussed a number of suggestions for regulatory changes to prevent a repeat of last year’s crisis.  He criticized Treasury Secretary “Turbo” Tim Geithner’s approach toward what amounts to simply baby-sitting for those financial institutions considered “too big to fail”.   Here is some of Mr. Volcker’s discussion on that point:

However well justified in terms of dealing with the extreme threats to the financial system in the midst of crisis, the emergency actions of the Federal Reserve, the Treasury, and ultimately the Congress to protect the viability of particular institutions – their bond holders and to some extent even their stockholders – have inevitably left an indelible mark on attitudes and behavior patterns of market participants.

• Will not the pattern of protection for the largest banks and their holding companies tend to encourage greater risk-taking, including active participation in volatile capital markets, especially when compensation practices so greatly reward short-term success?

• Are community or regional banks to be deemed “too small to save”, raising questions of competitive viability?

*   *   *

What all this amounts to is an unintended and unanticipated extension of the official “safety net”, an arrangement designed decades ago to protect the stability of the commercial banking system.  The obvious danger is that with the passage of time, risk-taking will be encouraged and efforts at prudential restraint will be resisted.  Ultimately, the possibility of further crises – even greater crises – will increase.

This concern is often discussed as the “moral hazard” issue.  William Black, Associate Professor of Economics and Law at the University of Missouri – Kansas City published an excellent paper concerning this issue on September 10.  He made some great suggestions as to how to deal with these “Systemically Dangerous Institutions”:

Historically, “too big to fail” was a misnomer – large, insolvent banks and S&Ls were placed in receivership and their “risk capital” (shareholders and subordinated debtholders) received nothing.  That treatment is fair, minimizes the costs to the taxpayers, and minimizes “moral hazard.”  “Too big to fail” meant only that they were not placed in liquidating receiverships (akin to a Chapter 7 “liquidating” bankruptcy).  In this crisis, however, regulators have twisted the term into immunity.  Massive insolvent banks are not placed in receivership, their senior managers are left in place, and the taxpayers secretly subsidize their risk capital.  This policy is indefensible.  It is also unlawful.  It violates the Prompt Corrective Action law.  If it is continued it will cause future crises and recurrent scandals.

*   *   *

Under the current regulatory system banks that are too big to fail pose a clear and present danger to the economy.  They are not national assets.  A bank that is too big to fail is too big to operate safely and too big to regulate.  It poses a systemic risk. These banks are not “systemically important”, they are “systemically dangerous.”  They are ticking time bombs – except that many of them have already exploded.

Mr. Black then listed twenty areas of reform where these institutions would face additional regulatory compliance and restrictions on their activities, including a ban on “all new speculative investments”.     Paul Volcker took that issue a step further with his criticism of “proprietary trading” by these institutions, which often can result in conflicts of interest with customers, since these banks are trading on their own accounts while in a position to act on the confidential investing strategies of their clients.

Paul Volcker made a point of emphasizing the need to clarify the overlapping jurisdictions of the Securities and Exchange Commission and the Commodity Futures Trading Commission (CFTC).  On September 18, David Corn wrote a piece about the CFTC, describing it as:

…  a somewhat obscure federal agency, but an important one. Its mission is to protect consumers and investors by preventing misconduct in futures trading that could distort the prices of agricultural and energy commodities.  In 2000, the CFTC wanted to regulate credit default swaps — complicated and privately traded financial instruments that helped grease the way to the subprime meltdown — but Republican Sen. Phil Gramm, then the chair of the Senate Banking Committee, Fed chair Alan Greenspan and Clinton administration officials (including Lawrence Summers, now President Obama’s top economic adviser) blocked that effort.  Had the CFTC been allowed to police swaps, the housing finance crisis that begot the economic crash of last year might not have been as bad.  So the CFTC is a critical agency.  And under Obama’s proposal for more robust financial regulation — which he talked about during a Wall Street visit on Monday — the CFTC would have greater responsibility to make sure no one was gaming the financial system.  Consequently, the composition of the CFTC is more significant than ever.

Mr. Corn expressed his concern over the fact that the Obama administration had nominated Scott O’Malia, a Republican Senate aide, to be a commissioner on the CTFC:

For the past seven years, he’s been a GOP staffer in the Senate.  But before that he was a lobbyist for Mirant, an Atlanta-based electricity company. According to House and Senate records, while at Mirant O’Malia was registered to lobby for greater deregulation at a time when his company was exploiting the then-ongoing deregulation of the energy market to bilk consumers.  Remember the Enron-driven electricity crisis in California of 2001, when Enron and other companies were manipulating the state’s deregulated electricity markets, causing prices to go sky-high, creating rolling black-outs and triggering a statewide emergency?  Mirant was one of those other companies.  According to state investigators, Mirant deliberately held back power to force prices up.

After the crisis, Mirant was investigated by various federal and local agencies and became the target of a number of lawsuits.  It ultimately agreed to pay California about half a billion dollars to settle claims it had screwed the state’s residents.  It also was fined $12.5 million — by the CFTC! — for attempting to manipulate natural gas prices.

Mr. O’Malia had previously been nominated for this position by President George W. Bush.  Nevertheless, Washington Senator Maria Cantwell helped block the nomination.  As a result, David Corn was understandably shocked when O’Malia was re-nominated for this same position by the Obama administration:

Yet Obama has brought it back.  Why would a president who craves change in Washington and who wants the CFTC to be a tougher watchdog do that?

The answer to that question is another question:  Does President Obama really want the CFTC to be a tougher watchdog or just another “lap dog” like the SEC?

After all the promises of the needed regulatory “clean-up” to prevent another financial crisis, can we really trust our current leadership to accomplish anything toward that goal?