Financial Reform Victory? You can’t reform vampires and zombies.
Friday, 10/16/2009 - 1:00 pm by Marshall Auerback | 13 Comments
The victory on financial reform claimed by the Obama Administration is not only unjustified, but delusional. Marshall Auerback argues that the monster-sized financial system must be downsized, and offers guidelines on how to do it.
If nothing else, the Obama Administration has learned the virtues of Clintonian spin. The so-called “financial reform victory” claimed today over approved new rules for over-the-counter derivatives is, in reality, akin to using a band-aid to treat gangrene.
Any kind of bill which (in the words of the Reuters report), “strives to balance a desire to curb speculative market excess with preserving the market’s useful role in helping corporations hedge against operational risks” ignores the fact that it is not the market playing a “useful role in helping corporations hedge against operational risks”, but the product of a big financial subsidy to Wall Street. Lack of transparency is a hallmark of these instruments and this gives huge pricing power to the banks. More importantly, it makes them tougher to regulate. There is no public, continuous record of Credit Default Swap trades that is comparable to the data available to investors and regulators from the major cash and derivatives exchanges, and the “reforms” introduced by the House of Representatives Financial Services Committee do nothing to address this reality for Credit Default Swaps.
This is in sharp contrast to the available pricing for other OTC derivatives, which is generally good and tracks the highly visible cash basis that underlie many other derivatives markets, OTC and exchange-based. Whether you are talking about currency swaps or a commodities related product, the world of OTC derivatives excluding CDSs is largely standardized in line with the exchange-traded products. Hence, they do not generate the same volumes of profits for Wall Street, which explains why the latter have fought to retain the status quo in spite of almost blowing up the entire financial system last year.
Obama clearly believes the BS fed to him by Jamie Dimon. I guess we should not be surprised; the President taught at the University of Chicago, after all, and clearly seems to have imbibed some of the Chicago School’s free market ideology, and the unspoken assumption that free, unfettered markets are the optimal state. Anything else is a distortion or a rigidity. That of course fails to address the problem of fraud, which my colleague, Bill Black, has tirelessly sought to highlight.
Dealing with fraud is not only an important moral issue, but also crucial on basic economic grounds.
If we don’t know what’s really going on, we can’t gauge whether the government’s economic policies are working or not. The advantages of living in a society governed by the rule of law require both the right laws that, with common agreement, public purpose, as well as enforcement sufficient to deter non-compliance in the first place. Laws that most agree are okay to break, and a lack of enforcement, break down the core morality of the system, and result in a dangerous degeneration into lawlessness.
Leaving aside political agendas, the truest test of any reform is: will it have any kind of positive effect? As far as the current financial regulatory reforms go, the answer is probably yes in a very LIMITED fashion, but that is more a function of the impairment of the capital markets themselves, which is precluding additional proliferation of these horrible Frankenstein financial products. If you don’t deal with a cancer fully, it comes back and spreads, even if you conduct surgery to remove some of the tumor the first time around. And, as any oncologist can tell you, it’s the secondary recurrence which usually kills.
Reform of the current US financial sector is neither possible nor would it ever be sufficient. It’s a bit like saying, “Well, this slavery thing has a few problems, but we can ‘reform’ it and make it better”. As any student of horror films knows, you cannot reform vampires or zombies. They must be killed (stakes through the hearts of Wall Street’s vampires, bullets to the heads of zombie banks). In other words, the financial system must be downsized.
Downsizing can begin with the following set of actions:
a) All bank assets and liabilities must be brought onto balance sheets, and made subject to reserve and capital requirements and, more importantly, to normal oversight by appropriate regulatory agencies. Any assets and liabilities that are left off balance sheet will be declared null and void, unenforceable by US courts.
b) All CDSs must be bought and sold on regulated exchanges; otherwise they will be declared unenforceable by US courts.
c) Unless specifically approved by Congress, securitization of financial products such as life insurance policies will be prohibited and thus unenforceable by US courts.
d) The FDIC will be directed to examine the books of the largest 25 insured banks to uncover all CDS contracts held. These will then be netted among these 25 banks, canceling CDS contracts held on one another. CDS contracts with foreign banks will be unwound. The FDIC will also examine derivative positions with a view to determine whether unwinding these would be in the public interest.
e) In its examination, the FDIC will determine which of these banks is insolvent based on current market values-after netting positions. Those that are insolvent will be resolved. Resolution will be accomplished with a goal of i) minimizing cost to FDIC and ii) minimizing impacts on the rest of the banking system. It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution.
These actions should substantially reduce the size of the financial sector, and would eliminate some of the riskiest assets, including assets that serve no useful public purpose. The financial system would emerge with healthier institutions and with much less market concentration.
Failing that, we should at least have the government get into the insurance business as credit insurer of last resort. Private firms can’t do it, as they do not have the financial resources to meet the potential claims (see AIG). And private firms have a tendency to mis-price credit risk (again, see AIG), which creates further incentives to bad behavior. As “Credit Insurer of Last Resort” (Professor Perry Mehrling’s term, not mine), the government can charge proper premiums for it, which will have the additional impact of mitigating the worst behavior of Wall Street. The government can put a floor on the value of the best collateral in the system. As Mehrling says (in a variation of the Bagehot rule - i.e. “lend freely but at a high rate during a crisis”)): Insure freely but at a high premium.
We can spend more time blogging about these issues, but now is the time to do something about it. As my friend Dean Baker has already noted, those disgusted by the rapacious and highly destructive behavior of our bankers can go to Chicago on the dates of Oct. 25-27th when the American Bankers Association is having their annual meeting and make yourselves heard. If we stay quiescent, we’ll get the kinds of “reforms” we deserve. To paraphrase Rahm Emanuel, it’s time to ensure that this crisis does not go to waste.
Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.
“b) All CDSs must be bought and sold on regulated exchanges; otherwise they will be declared unenforceable by US courts.”
I believe a court has already ruled this way, at least once, I think in Kansas…a homeowner was not forced to give up their home because the bank could not prove it owned the mortgage, since it had been bundled into CDSs.
Posted by Zach P | October 16th, 2009 at 1:29 pm
“We can spend more time blogging about these issues, but now is the time to do something about it. As my friend Dean Baker has already noted, those disgusted by the rapacious and highly destructive behavior of our bankers can go to Chicago on the dates of Oct. 25-27th when the American Bankers Association is having their annual meeting and make yourselves heard.”
I hope they’re prepared for preemptive raiding by SWAT teams, detention at gunpoint without warrants, harrassment, use of urban warfare tools against them, etc. Just look at the G-20 or the RNC convention last year. Protests against those in power are pretty much being made illegal, except when conservatives do it (see tea parties/9-12 march).
Posted by Zach P | October 16th, 2009 at 1:36 pm
Marshall has noted the irony that the protest is happening in the very city where faulty models of economics got their foothold…
Posted by FERI | October 16th, 2009 at 5:38 pm
FERI, glad you picked that up! Who says Americans don’t do irony?
Posted by Marshall Auerback | October 16th, 2009 at 5:59 pm
Most of this has too much self-evident common sense to have any hope of being introduced, let alone passing in an idocracy of kleptocrats.
However, I am not sure I understand the statement
“any assets and liabilities that are left off balance sheet will be declared null and void, unenforceable by US courts.” Predatory fraud, of course, is almost always off the books, and its victims should always have access to legal remedy.
It is also obvious that we need much more than essentially toothless regulations about unenforceable contracts. We need severe, painful penalties for fraud and malfeasance, with real risks to the freedom of predatory perps, beyond the laughable cost-of-business fines we have now.
Posted by Doug Terpstra | October 17th, 2009 at 3:11 pm
Thanks Doug. I was thinking of the “Special Investment Vehicles”, used by the likes of Citi. I agree these largely were fraudulent, so you could argue that a regulation would be specious, but since the banks game the system constantly, let’s have it all up there in black and white. As an aside, what do you think Jeffrey Skilling and Andrew Fastow are thinking these days? They constructed those “Special Purpose Vehicles” for Enron? What’s the difference? They got jailed for fraud, but Citi’s execs leave the company with multi-million dollar payoffs AND their company gets a taxpayer bailout!
Posted by Marshall Auerback | October 17th, 2009 at 4:55 pm
No matter how much blood you pump into a zombie, it’s still a zombie.
Posted by lambert strether | October 17th, 2009 at 7:55 pm
Marshall, I read you for years at the Prudent Bear. I believe you are on the right track. The problem is deep and it involves the fact that the only solution the government and their cronies can see to this problem that doesn’t immediately involve the resolution of it is piling more debt on top of more debt. The idea the general population or the corporate sector could liquidate their debts in a normal lifetime is way out there. People rely on perceived inflation to inflate the current value of what they own and what they appear to earn. Nothing touches reality because the perception it this is like a tree that can grow to the sky. It isn’t. As your compadre Doug Noland wrote for years, a debt bubble is a debt bubble and eventually it becomes a Minsky moment.
Posted by mannfm11 | October 19th, 2009 at 1:26 am
i read the banks actually taught Enron how to set up these off balance sheet operations in the first place. I believe so much of 2008 was spent trying to hope the insolvency of Citi went away. I don’t believe we are in a solvable crisis because the amount of debt is either going to ensure we deflate or have a financial collapse. The Fed and the government haven’t fixed this, but made it worse and it is a sad state of affairs that the very people that fiddled and created the mess in the first place are now running the show. They only know how to make it worse. I sense there are enough people that should be in prison over this mess that a good stimulus package would be building the prisons to house them. Michael Milken type fines could pay for the construction.
Posted by mannfm11 | October 19th, 2009 at 1:30 am
There is one thing I have not read or heard mentioned in the discourse on this crisis — although I do not claim to have heard or read even a small percentage of everything out there. that one thing is the effect of investment banks such as Goldman having gone public in the last decade or so.
Traditionally, investment banks were private firms. While their business involved risks that commercial banks were barred from taking (sidebar: let’s bring back Glass-Steagall!) they remained relatively prudent by today’s standards. This, I believe, was because it was the partners’ own money at risk. If they took enormous risks and failed they were personally wiped out.
But all that changed when they went public. Now they could take bigger and bigger risks with essentially no consequences for failure. Is it any wonder that we’re in the position we are today?
Some may say that we can’t put the genie back in the bottle but I am not one of them. If there were only the will I’m certain we could find the way.
Posted by Victoria Posner | October 19th, 2009 at 11:20 am
Victoria, that’s a very good point. Believe it or not, I think Alan Greenspan, no less, has mentioned the loss of the partnership structure as one of the factors behind the crisis. And I agree that it is (as you do, I assume). I don’t think you can re-establish that structure, but the compensation structures surely have to be reformed so that the banks don’t always think they are playing with other people’s money. One possible solution is one mooted by the UK Financial Services Authority, whereby the bonus element of compensation is paid over a period of years (5 was the suggestion) and that there by clawback provisions in the event a bet goes bad. That would at least be a start.
By the way, I’ve enjoyed your posts over the years as well.
Posted by Marshall Auerback | October 19th, 2009 at 6:02 pm
Thanks for the compliment.
Here’s an idea for re-privatizing the investment banks — hire (nationalize?) KKR, etc. and have them take the firms private. A bit cockamamy but hey, aren’t we more or less in the Twighlight Zone these days?
Posted by Victoria Posner | October 20th, 2009 at 10:48 am
A bit rattled by the eminent good sense of this post and its comments. Appreciate it immensely.
Bringing these companies and products into the light is really bringing them into a functioning market. Markets do have discipline. A lot of intrusive regulation would be unnecessary if the products themselves were regulated in the vanilla style and the purchase-sale were out in the open.
In terms of the rewards to the big players, again, rather than intrude into the business of individual companies, why not just tax away incomes of the obscene dimension, say over a million or two a year? The Treasury could use the money. The primary critics of government deficits are located in the top income percentile. And it would make my baseball team more competitive with the Yankees. It is hard to see how these types of incentives are anything other than incentives to do the wrong thing.
I know. Politically impractical. But the whole system is not being reformed or restructured, and it seems inevitable that another crisis has to be the result.
PS: Correct me if I’m wrong, but doesn’t Minsky’s algebra demonstrate that the deficits are the source of the profits of these companies?
Posted by Alan Harvey | October 22nd, 2009 at 12:55 pm