bailouts

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Citibank; Volcker and The Banks

It seems like an age since I was filling this space with my opinions about the pros and cons of nationalization. In terms of bank earnings it has been an age: the big banks have all done extremely well this past year. Not that they could have fouled up in such a featherbed environment, rigged as it is to their advantage.

Interest rates remain extraordinarily low; the yield curve is tilted sharply upward; liquidity is sloshing about as never before; the government maintains its safety net; competition is severely reduced by the loss of some key players; and efforts to re-regulate the industry look to be tinkering around the edges rather than striking at the heart of what the industry does.

Yes, life is good for the gamblers bankers of America.

Which is why there has been a torrent of repayments of that infamous TARP money. Goldman got the ball rolling and now every one of the big banks who were saved from themselves by our collective generosity have either paid the TARP cash back, or have announced plans to do so imminently.

As taxpayers that’s a good thing: we get our money back. But if you’re a bank shareholder I wonder whether this rush to repay the public is such a good thing.

Take a look at Citibank.

They are paying back their TARP money. This isn’t because they have suddenly become rock solid. Far from it. It is because they want to get out from underneath those annoying rules the government imposed regarding bonuses.

So paying back TARP cash is a jolly good thing if you’re a Citi banker. Not so much if you are a shareholder.

Why?

Because the handing back TARP leaves a hole in the bank’s capital account and thus makes it much less secure. Naturally even the thick headed folks running the bank notice this and have planned to raise capital to offset the TARP cash. This has two effects, neither good.

First, it dilutes the ownership of the existing shareholders. The new shares may fall into the hands of people who currently have no Citi stock. The managers may like this extension of the ownership base, but the existing shareholders will now have to share future profits with a whole bunch of newbie owners: they’ll get less of a share. Having stood by the bank during its dark hours last year and early this, they may find this dilution a less than generous reward.

Second, the TARP money was relatively cheap. The annual cost of capital was low compared with the cost likely to attach to newly issued equity. So the bank’s management has raised its cost of capital, and thus reduced its ability to make the same level of profit from its lending activity as it had with TARP cash. In other words management has deliberately lowered its profit run rate.

So the net effect of the payback seems to be that the bank is no better off in terms of capital. If anything it may be weaker: it could have raised new equity and kept hold of the TARP money for a longer period. The new equity would then have bolstered capital rather than filling the hole left by the TARP repayment. Plus the bank’s future earnings could be depressed slightly by that higher cost of capital.

Capital no better and earning potentially weaker. This doesn’t sound like a good plan.

Except if you are an executive eyeing that big bonus you would have been denied while TARP still cluttered your balance sheet. Then the scheme makes perfect sense.

Then of course is the public indictment that would have followed from Citi being the only bank not to pay TARP back. That would not have looked good. It would have inevitably drawn our attention to what has been unstated all year long: Citi is still in bad shape. Even though it is earning a profit it is stumbling about without a certain hope of survival. It’s recovery will take many years, and one blow from the economy – commercial real estate perhaps – could be enough to finish it off.

There is a line of thinking that says the TARP repayment is sensible from the public’s point of view: we got our cash back. But what happens when Citi trips up again. Its current management doesn’t inspire confidence and its business model is a convoluted mess. The words ‘Citibank’ and ‘decisiveness’ sit uneasily together. This is a bank being propped up by those extremely favorable conditions I mentioned at the outset. One storm is all it will take to reveal the rot that still remains.

Then what happens?

Presumably Citi comes running back for a new bail out.

This is should not get. Instead it should be nationalized, broken up and sold off in pieces. And its current managers should all be fired.

Interestingly the idea of breaking up the banks is gathering support. Paul Volcker had been, up until recently, a lone voice arguing the case for this idea. Alan Greenspan had joined in, but elsewhere the notion had been consigned to fringe status. Now, however, Volcker’s idea is beginning to attract more support, some of it in Congress. There is hope yet. I have been a big proponent of smaller banks from the beginning of the crisis: they are easier to push through bankruptcy; they are less ‘systemically’ dangerous; they are more agile and responsive to customers; they are less able to rig prices and markets for profit; and the fact that there would be more of them implies greater competition and thus lower prices. All these things are in the public interest. I have yet to see a convincing counter argument presented.

Of course there are variations in the way in which we would break up the banks. Would we break them up along product lines as in the old Glass-Steagall Depression era legislation? Or would we simply break them apart geographically? These details need to be worked out, but one thing we cannot avoid is that the banks have now grown to the point that the phrase ‘too big to fail’ hangs all too easily on the public’s lips. As Volcker has said: too big to fail means too big to exist.

Actually in reality too big to fail implies too big to bail out as well. We cannot afford the banks any longer. They have outgrown our economy’s ability to absorb their losses. By vectoring off into the alternative universe of purely paper transaction making – securitization, derivatives of derivatives etc – the banks have inflated themselves so much that they dwarf the real economy. But it is on the cash flows within that real economy that they rely for the guarantees that keep them afloat. Remove those guarantees and the entire edifice has to shrink rapidly down to be accommodated within the real world.

Let’s keep this simple: the social value of banking is its ability absorb time based risk – ‘intermediation’ – and in its superior ability to allocate capital. The profit motive should provide sufficient discipline to ensure that the banks provide these benefits without destroying their shareholder’s value and thus coming to us for a bail out..

That discipline broke down when the banks realized that they had become too big to fail. This realization led them to take excessive risk for the personal gain of their employees, safe in the knowledge that they had a public safety net to fall into. In other words the moral hazard economists bemoan so much had become a reality.

Since we do not want to remove that safety net: it exists to protect our money when a bank fails we run the risk of fostering ongoing moral hazard, and thus the likelihood of further financial crises. The managers of the banks have little incentive to act in a socially responsible way. At the risk of boring you: bank managers have become poster children for the concept of ‘rent seeking’ behavior.

All you need to know about rent seeking is that is a bad thing. Wherever someone can rent seek the relevant market is subject to imminent failure because the essential dynamics of capitalism have been twisted for personal gain.

So it remains with banking: case in point Citi’s repayment of TARP cash in order to free it up to pay out big bonuses.

The only serious way to keep those safety nets to protect our deposits when a bank fails, and yet get rid of the rent seeking enabled by moral hazard, is to make the banks small enough that we can allow them to fail. In other words we re-introduce a dose of capitalism. Competition is the central mechanism that makes capitalism work. The big banks have grown so large that they can blunt the impact of competition. They have become ‘oligarch’ like. They can distort the rules. In fact some of them – Goldman in particular – won’t play in a market that it cannot distort to its own advantage.

Moral hazard breeds rent seeking, which leads to anti-social behavior. The only disinfectant sure to work is heightened competition and the withdrawal of the too big to fail feature of the current system.

That means breaking up the banks.

Get it done and the economy will benefit enormously.

Meanwhile: if you own Citibank stock, watch it like a hawk. That bank is still very unsteady.

Addendum:

I forgot to mention that I think the rush to pay back TARP by all the other banks is a combination of a domino ‘fairness’ effect – once one was allowed the rest had also to be allowed – and politics. The government can present the repayments as a ‘win’ for its handling of the crisis.

What it cannot do is claim to be reducing the Federal deficit: TARP was never accounted for at its full cost. Rather it was accounted for on a ‘net’ basis. This means that only the money the government estimated would never be paid back made it onto the books as a cost. The rest was accounted for as a loan … which is what it was. This is an oddity in that the government doesn’t usually account for assets and liabilities, it uses a variant of cash accounting and has no balance sheet to speak of. Sometimes it simply doesn’t report things at all – see the Iraq war costs under Bush. This messy accounting has always been a pet peeve of mine, which is why I bring it up!

Update:

Now we read that the Treasury Department is having second thoughts about disentangling itself from Citi. The reason is that the equity issuance – Citi raised about $20 billion in what is the largest single equity issuance ever – needed to refill the hole left by paying back the TARP cash went badly. The money was raised but the market was not impressed. Citi even now finds itself being sued by Abu Dhabi whose investment authority is claiming that it Citi misrepresented its financial condition. The net result of this latest mess is yet another black eye for Citi’s management and a setback for the administration. The former wanted to get out from under close government supervision; and the latter wanted not to be embroiled in a protracted relationship with what could be a dying bank.

The story continues …

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Whacky Bond Markets

With deficit hysteria now growing with each passing day the risk that our leadership will blink and do something really dumb like raise interest rates gets larger. You all know how stupid I think such a move would be, but, hey, this is the all-knowing bond market we are talking about. You know that place inhabited by ultra smart, uber brilliant investors who hone their computer analyses and are invariably right about absolutely everything.

Like mortgage backed securities.

I suppose I am not allowed to point out the fallibility of the gods of Wall Street.

They seem to have such short term memories.

So do all the commentators who pay attention to them.

Let’s be honest we need to sell bonds. That makes the folks who buy them pretty important right now. We need to keep them all happy. To an extent.

You see investing is a two way street. We need them to buy our bonds so we can spend like crazy and bail ourselves out of the economic mess created by the insanity of the big banks and other investment companies who failed to analyze risk properly back in the run up to the big credit bust of 2008.

And they need us. Where else are they going to park their cash? There is a limit to the places all that investment can go right now. Think about it: the private sector is simply not investing. It is hoarding cash. Part of that hoard finds its way into our bonds. I realize that most of the stash goes into Treasury bills, which most folks regard as cash rather than as investment. But for the longer term investor US bonds are a safe bet. After all the possibility of a US default on its debt is just absurd.

Or not.

Here’s the fun part:

The activity in those notorious Credit Default Swaps on sovereign debt – i.e. the debt of a country rather than a company – has picked up a goodly pace. And not just on the places you would expect: Russia, the Ukraine, and so on are fairly weak economies with a track record of playing fast and loose with the bond markets. No the real action is now in CDS’s on US and UK debt. Spreads have widened a bit recently indicating that someone, somewhere, is a little nervous that the US will default on its debt. So those people are buying insurance in the form of CDS contracts just to be safe. That way when the US implodes totally and refuses to pay back its debt these wise folks can collect their money anyway.

Very clever.

And where do they buy these insurance contracts? Who is it that will be left standing even after the US has crumbled into ruin?

The big banks.

Ummmm.

Would these be the very same banks that rely on the US for bail out cash?

Yes they would.

Let me ponder this for … oh … all of a second.

Someone pays the big banks to provide them insurance against a default by the very Treasury responsible for shoring up the same big banks.

No I know I can be dumb sometimes, but help me out here. If the US Treasury defaults on its debt, just how stable will those banks – or any others – be? More to the point will they be there the day after in order to pay up on the CDS contracts?

Didn’t think so.

This is just one more example of the whacky way in which analysts and commentators get their proverbials in a gigantic twist.

So obsessed are they, and much of the financial media, with US debt levels, that they have taken leave of their senses. They actually think that Goldman Sachs, for example, is more credit worthy than the US itself. That would the same US that bailed Goldman out last year.

Not happening.

But because the analysts and commentators are getting hysterical about debt they no longer think of simple things. They are fixated on that debt level and see the end of the world all about them. We read silly articles about the US going the way of Argentina. We read about the urgency of tightening the Federal deficit and raising rates even though that would precipitate a Depression. We read about the profligacy of the US government and about its enormous unfunded liabilities.

And some people read all that and rush out to buy CDS coverage against their US bond portfolio.

I have a bridge I would sorely like to sell these people.

They would probably buy it if they knew Goldman Sachs was selling it. But they’d never buy it from its actual owners, because the owners are a government. And governments are the problem to quote my favorite incompetent president.

Sorry to be so sarcastic. But really. These are the self same geniuses who nearly sank the world economy. They bought toxic assets with unfounded glee and abandon. They packaged and securitized their mothers for all I know. Their credibility is zero. And now they bitch about the debt levels we need to reach in order to straighten out the mess they made.

Ugh.

On a serious note. For those of you who want to track just how the grown ups feel about our fiscal condition – which means turning off cable television – keep an eye on the spread between US bonds and the inflation proofed version of the same. That spread gives us a good indicator of just how much risk there is perceived to be in US debt. Not much given the latest data. Or you can take a peek at the US bond rates themselves: not very high at all. Or, for the truly daring, take a look to see if Goldman’s debt costs more then the US treasury debt does. Which is thought of as the riskier?

Get my drift?

Here’s the thing: yes our debt levels are shooting up. Hello: we have a crisis to deal with! Much of the deficit creating that debt stems from a drop off in revenues: people who are unemployed tend not to pay much income tax. Profits tend to be weaker in recession so businesses pay less tax too. Duh! Top that off with the need to bail out the banks and kick the economy into gear and we end up with an awful debt level. But it isn’t permanent. The deficit starts to drop off the minute the economy grows. So the ratio of debt to GDP peaks and then falls as soon as we get going again. GDP growth itself will lessen the ratio as long as we don’t keep our foot on the accelerator after the recovery is well established. And no one I know is saying we should. On the contrary I think there is too much premature talk of tightening. That moment is still someway off. We all want fiscal conservatism down the road. That means taking a good hard look at the budget and cutting some stuff out. It also means raising taxes at some point. Sorry folks nothing’s free.

If there’s one thing that the years of illusion should have taught us it is that the Federal budget should be balanced now and again, especially in years of good GDP growth.

Yes Messrs Reagan, Bush, and Cheney: deficits do matter. They always did.

Meanwhile let the bond market have its whacky moments. At some point as we pay down debt we will start to hear the lament of the late 1990’s: we need more debt! After all where are the investors going to get a safe return?

CDS coverage on US debt.

Please!

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News Round-Up

So far the news this week has been very ordinary. Nothing suggests we need to change our expectations about next year that much. That is if we accept the likelihood of a very slow recovery with continuing downside risk. The point being that we have not yet begun to see data that foretells a strong upswing. Things remain tepid to say the least.

Leading Indicators:

Take yesterday’s leading indicators for instance: they rose for the seventh straight month, which is obviously a good thing, but the increase was much weaker than the previous month – the index rose 0.3% in October and 1.0% in September. In fact October’s rise was the weakest in six months. So any headline proclaiming that the recovery remains firmly on track is technically correct, but it misses the crucial aspect of much recent data: there is no momentum. We have forward motion, but is appears to be either fitful or weakening. Our language now is reverting to the inverse of that we used earlier in the year. Back then we spoke of things getting worse ‘less slowly’. Now we speak of things getting better, only less slowly.

I call it sputtering. That’s a technical economics word reserved for dubious and unpredictable growth.

We are definitely sputtering.

Unemployment:

The other data yesterday reinforced this general view. The weekly report for new claims for unemployment assistance showed that we remain stuck just around the weekly loss of 500,000 jobs. Remember that this is not a count of actual net jobs lost because it does not include any reference to new jobs being made, and even in this economy there are new jobs being created all the time. Just nowhere near enough. The good news within the claims data is that the trend is still down: the four week moving average dropped very slightly once more to 514,000. The bad news is that the number of people making long term claims is still climbing and has now reached 4.23 million. Obviously, and this is no news at all at this point, the job market is a very long way from being healthy.

TARP:

It may have slipped your memory but last year we, the taxpayers, provided a ton of money to the banks so that they could pay themselves fat bonuses this year survive. This week’s report by the person installed to take a look at the way TARP was managed – an ex-Goldman guy, who knew there were so many of them? – criticized the Fed’s handling of the way in which the AIG bail-out ended up being a back door bail out of other Wall Street firms.

Surprise.

The issue back then came down to the extremely weak leadership the Fed displayed as they sought to push back against the counter parties who had purchased those infamous Credit Default Swaps we all read about – and contributed to – late last September.

The story goes this way:

AIG sells a ton of totally insane CVDS contracts. The contracts are insane because AIG has nowhere near enough money to pay up on those contracts were they to come due in a cluster. No matter: the geniuses earning those massive bonuses at banks like Goldman and Citi all decide that the risk of a cluster default is so small no one needs to care – and these folks are still employed? – so they not only buy covered contracts they buy ‘naked contracts as well. Lots of them. A ‘naked contract being one where I buy insurance against something I don’t own … like me buying life insurance on your death. These naked contracts are tons of fun and make lots of money for the gamblers traders who get away with it. The problem is that by piling up lots of naked contracts the system is now awash with insurance against a much smaller number of possible events. So instead of stabilizing the market by offering sensible insurance against a default, they destabilize it because single event can cascade across the balance sheets of banks who weren’t even involved in the original deal being covered.

Back to the story …

When the economy soured last year it turns out that the geniuses had been dumb as all hell – are these people still employed? Apparently none had noticed that AIG was way too small to pay up if a cluster of defaults swept through the economy. It’s actually more technical than that: the terms of these contracts includes the posting of collateral. The clever people at Goldman etc realize that it might take time for AIG to get the money together to pay off on the contract so they ask for front money. You know just in case something really insane happens like we need to call in the contract. No that will never happen. But horrors it did. As the credit market tanked the geniuses started to get itchy and asked AIG to ante up more front money. AIG looked in its piggy bank, realized it was empty, and ran to the Fed for help.

Basically the cry from AIG was: bail us out or watch the banking system melt before your eyes.

The Fed, being full of ex-bankers and bank sycophants, jumped right in. They decided to pour in the money needed for AIG to make good on all the calls being made against it.

The big question became how much money is needed?

That’s where the Fed failed. And we ended up getting gouged. Royally gouged.

The big criticism is this: the counter-parties were trying to enforce contracts that, in the absence of the taxpayers, were worth either nothing or, at best, a few cents on the dollar. But AIG was not in bankruptcy, it was being bailed out. So the Fed decided it had, legally, to abide by those contracts. It tried to get the counter-parties to agree to take a hair cut – take less than the 100% they were owed. Only Credit Suisse agreed. All the others, including Goldman, JP Morgan, Citi, Wells Fargo, Bank of America and all the other rogues gallery of taxpayer beneficiaries told the Fed to get lost. They guessed – or knew – that the Fed would have to keep AIG afloat and so the cards were in the bank’s hands. Naturally the Fed, being a Wall Street groupie, caved in and we ended up larding the banks with cash that they most likely would never have seen otherwise.

It appears that the Fed held out on our behalf for all of a nanosecond.

The lawyers will all cry that the Fed have no option: those contracts had to be honored.

To which I reply: balderdash. We had the money. They wanted it. The question is now how much. I would have let them sweat over a weekend. Let the geniuses contemplate their potential losses. then force them to take a decent haircut. Not enough to sink them, although they surely deserved to sink given their stupidity, but enough to make them feel the pain. And enough to reduce the taxpayer bill from the stratospheric levels it late became.

All this has a happy ending of course.

Goldman is back to paying egregious bonuses. AIG complains daily about the invasive nature of its government overseers who – gasp – dare to suggest that the dimwits who nearly sank the Western world should collect merely sensible bonuses this year rather than the normal insane ones they are used to.

The Fed chugs on happily cow-towing to Wall Street. And Tim Geithner, who master minded the cave in, has been promoted.

So all is well.

At least that’s what they all say.

I say we’re headed into another finance inflamed crisis – watch those emerging market asset prices as they streak skyward aided and abetted by our neighborly geniuses.

Are they still employed?

Unfortunately, yes.

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Contingent Convertible Debt? A Quick Primer For Finance Jocks.

Just a quick addition to my comments so far this week:

Just when you thought it was safe, out pops another miserable acronym. Finance is awash with silly names and jargon – those lawyers must be paid huge fees to think this stuff up.

Today’s hot new acronym is ‘Co-Co’, as in contingent convertible bonds, is becoming all the rage in banking discussion circles.

Just what are these ‘co-co’s’?

They are a new breed of bond a bank can issue that acts like a true bond during normal economic times, but which can be triggered into pure equity when a bank’s capital is under stress. This may seem arcane, but I think the idea has some merit, and may even help reduce the need for future bail out cash from taxpayers when were we to experience another banking implosion.

There have always been convertible bonds: they are structured such that an investor can convert an investment from debt to equity under certain favorable conditions. This mechanism is biased to favor the investors and induce them to participate in a company’s stock growth by allowing them to covert debt into stock at a predetermined price. This gives a bond investor a share in the equity gain a growing company may experience, yet protects them from any downside risk: if the company’s stock price drops the bondholder simply doesn’t convert and thus protects the investment. If the stock price rises the bondholder converts into equity and shares in the gains. This structure is why many start-up companies find themselves funded through convertible bonds rather than straight equity.

So traditional convertibles have been designed to favor the bondholders. Not so with ‘co-co’s’.

Essentially a co-co bond acts as if it were a form of regular long term debt until the terms of its trigger mechanism move it from one slot on the balance sheet to another. This move is a key one: creditors, like normal bondholders, do not anticipate losing their investment when a bank’s capital is stressed by things like loan losses. Those losses are absorbed first by the shareholders through their loss of the capital they have invested in the bank. When that capital is exhausted the bank is insolvent and goes into bankruptcy – unless it is too big to fail of course, in which case taxpayers bail it out. Notice that in this process the bond holders are treated as if they were ‘normal’ creditors. Their investment is at risk and may be subject to a ‘haircut’, but they have legally accepted rights in bankruptcy that they can enforce in court and thus have the ability to gum up the works and prevent a quick resolution of the bank’s problems.

This legal standing appears benign, and in non-financial companies it usually is dealt with in bankruptcy court, but in a bank the option of a lengthy legal battle flies in the face of the public interest which is to protect the banking system from a knock-on run on healthy banks. So regulators are often forced to protect bondholders as well as depositors in a bank insolvency through the need for expeditious action. This is nonsense since the purpose of the public safety net is to protect depositors not large scale and sophisticated investors. More to the point, bondholders are often negligent in taking preemptive action when they see a bank entering into profit difficulties: they know their debt is protected so they tend to avoid getting involved in pressuring bank management to act more forcibly. Plus many big banks are bondholders in other financial institutions so they are reluctant to boss around their fellow bankers. Even worse: some large banks, Goldman Sachs is particularly prone to this, hedge their bond positions by taking out credit default swaps. This means that they will be paid back their investment via the CDS insurance regardless of whether the bank has the resources to pay them or not. Following this thought further: if a bank like Goldman holds a CDS for the full value of its investment it will more than likely receive more money back were it to allow the bank to cave in, than were it to renegotiate the terms of its loan in an attempt to keep the bank afloat. Clearly this creates a huge conflict of interest and potentially a motive for anti-social behavior.

So bondholders often represent a roadblock to keeping a bank afloat because they have no economic interest in renegotiating its debts – those CDS’s may cover them anyway. Then, after the bank goes under, they are often swept up in the warm embrace of the public safety net even though theat safety net was never designed to protect them. This is a classic case of the ‘rent seeking’ I have been going on about lately.

This new concept of a co-co ends this ability to rent seek by forcing the bondholders to confront the looming loss of their investment. They will have the option to force management’s earlier action, and thereby try to rescue the bank and their investment, or they will see their bondholder status converted into pure equity where the bankruptcy process is harsh. Either way the public gains: the bondholders are forced to be active investors, or they stand to lose their privileged position in the winding up process and are no longer able to be scooped up in protective net the taxpayers provide to depositors. This makes for cheaper bail outs in future.

The bank benefits also by having an emergency cushion of equity that will kick in just at the moment when it is highly unlikely the bank can raise fresh equity from new investors.

The idea of a co-co style bond is still very new, and is subject to much debate. But if it acts in the way I have just described, it will be another brick in the wall as we rebuild a better regulatory system and safer banks.

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Finance Reform

Well things are heating up. Senator Dodd released his much awaited – by people like me that is – proposed legislation for the reform of our broken down financial regulatory structure. The legislation weighs in at 1,136 pages of text, so I doubt whether anyone has read it yet unless they received a copy ahead of time. I certainly won’t be wading through it all. I will use the executive summary as my source for the major proposals.

Here are the highlights, or ‘lowlights’ if you’re at the Federal Reserve Board:

  1. Dodd proposes to establish a single large new regulatory agency[the Financial Institutions Regulatory Administration or ‘FIRA’], similar to the FSA in the UK, that will take over many if not all the regulatory powers now vested in the warren of agencies in Washington. The idea behind this centralization is to prevent banks from getting themselves regulated by the most lenient overseer. This ability to shift the regulator with oversight over your bank – an ability known as ‘regulatory arbitrage’ – undermines the current system and allows banks to cherry pick the regulations they want to be governed by. Ending this ability is key to future enforcement. I have doubts whether Dodd will get his way with this proposal, the current agencies all have cheering sections in Congress and the massive inertia within the American system will most likely kill the initiative off. Plus centralization in the US is simply a first step: international regulation needs to be tightly synchronized as well is we are to eliminate global regulatory arbitrage.
  2. Once FIRA is set up the current Offices of Thrift Supervision and Comptroller of the Currency would both be abolished and their functions absorbed into FIRA. Likewise the bank regulatory aspects of the FDIC would be rolled into FIRA as would those of the Federal Reserve Board.
  3. The proposal also gives the SEC an ability to fund itself by keeping the fees it levies on the financial industry.
  4. A controversial aspect of the Dood reform is that it establishes a Consumer Financial Protection Agency [‘CFPA’], which is designed to monitor and control the products that banks create and sell to consumers. This is obviously a reaction to the sub-prime mess when lenders ran amok with fancy, and often incomprehensible, loan types, and then sold them to people who were not credit worthy if the fine print in the loan ever kicked in. Naturally the fine print always kicked in and precipitated the mass of delinquencies and foreclosures we are now cleaning up. I like this idea. The so-called innovation in banking is not innovative at all. It is simply an endless permutation of the same old products wrapped in ever more obtuse legal language. Innovation is supposed to drive higher value to the customer, but most bank ‘innovation’ is designed simply to open new sources of fee income for the banks. This proposal is vehemently opposed by the Republicans – they object to anything that seems to limit the good deeds of the market place – and the various bank lobby groups are pouring money into a fight to stop its successful passage. Given that both the House bill and the Obama administration endorse a similar concept, the odds are that we will get some form of CFPA. Good.
  5. Dodd also proposes setting up a new agency to govern financial stability. This agency is the lynchpin of the new Dodd style system of limiting the damage ‘too-big-to-fail’ banks can do to us all. The idea behind this agency is that it would monitor and manage the systemically important organizations – think Citicorp or Goldman Sachs – and suggest rules and limits on their activities to prevent their gambling taking us all down the way they did in 2008. The need for such an authority is an open acknowledgement of the total failure of the current system to account for the risk embodied in all the interconnections between the biggest banks. Remember it was our complete failure to understand systemic risk that led us to have to bail out AIG and bail out pay off Goldman Sachs et al through the back door by honoring those counter-party positions they had all foolishly entered into. The overall notion in this initiative is to limit the extent of the socialization of losses needed in future – Dodd’s fine print even has this agency given the power to recommend breaking up banks that are deemed too large for the safe operation of the entire system. Also good.
  6. The proposal also includes a raft of measures designed to discourage banks from becoming to big. In this respect Dodd’s legislation fits right in with all the other proposals floating about. This is also a welcome change, although I remain skeptical about its impact: we have capital regulations now. The question is getting them enforced.
  7. Small banks would find themselves subject to federal regulation if Dodd gets his way. This will annoy all those country bankers who have a cozy relationship with their local state regulator. It is about time we abolished the state level regulatory structure – not only does in encourage regulatory arbitrage, it helps maintain a fragmented industry. The proliferation of small banks prevents the emergence of new medium and larger banks that could compete with, and therefore limit the growth of, the existing mega banks. If we believe in a market system then we need to ensure that system is full of competitors and is not dominated – as it now is – by an oligopoly who can impose rents on the rest of us. {Rent seeking is the word economists use to describe activities where one person or organization can extort wealth from others by employing legal, but non-competitive, methods. Enforcing a patent is an example. Lobbying and getting preferential legislation is another}. One way to limit the damage of the pervasive rent seeking now current in finance is to encourage the emergence of healthy and innovative competitors. Getting all our small banks onto one regulatory playing field would be a step in this direction because it would probably encourage consolidation across state lines, where asnow the various State regulators discourage such activity.
  8. The last big change Dodd proposes is to bring all hedge funds under a strict regulatory framework. They would be required to register with the SEC. Further: hedge funds and private equity firms would be subject to capital requirements for the first time and may even be broken up if deemed systemically too large. This is a major step towards bringing the so-called ‘shadow banking system’ into the daylight and set up under the same controls as the normal system. This is a very good move.

That’s about it.

Predictably the Fed and the FDIC have already mounted the barricades in defense of their entrenched positions. The Fed’s big criticism of the Dodd proposal is that it strips away their ability to use their regulatory control of big banks as a way to take the pulse of the economy – they regard this ‘touchpoint’ as an important source of information as they manage the money supply. They also reject the measures the proposal includes to open up their activities to wider scrutiny – by making appointments more subject to public input for instance. They are wheeling out the dreaded ‘the Fed must be politically independent’ defense tactic, which is sure to energize the financial market and right wing analysts to become allies of the Fed.

I agree the Fed should be independent of direct political control. Its Board should have a mandate unfettered by political agendas. But, just as important, the Board should not be dominated by the banking industry – the Chairman of the New York Fed is an ex-Goldman executive who was trading his Goldman stock at the same time as sitting in on meetings to determine who should, or should not, be bailed out. It is this clear conflict of interest that Dodd is taking aim at, not political independence.

In any case the recent record of the Fed just doesn’t stand up: they are so embedded with Wall Street that they are incapable of executing a regulatory mandate effectively. They have swallowed the same free market ideology that misled the banks and even now don’t seem willing to admit much by way of error during that 2002-2007 period when the current bubble was being inflated largely as a result of Fed policy and inept oversight.

I will end with this latter point: defenders of the Fed loudly proclaim its need for independence. But in a broader sense the Fed, under Greenspan in particular, was anything but apolitical: it was a vehement advocate of the same theory and ideology that was the foundation of Reagan/Bush style Republicanism. Greenspan, more than once, intervened to prevent regulation of things like derivatives, and openly supported the modern Republican view that government is a problem and not a source of solutions. While I admit the entire political world has been infected with this worldview – Rubin and Summers in the Clinton years were just as culpable – the Fed under Greenspan became more than usually tainted by a particular political point of view.

So the question becomes: can the Fed ever be ‘independent’? Or is the search for independence simply a cover for its adoption of free market ideology?

This is not academic.

The big discussion at the Fed currently is when and whether to raise interest rates. Those that want higher rates advocate a raise because they want to defend price stability – they are afraid of inflation – which is one of the Fed’s two legal mandates. They are by and large are the free market folks. Those that push back are driven by the other mandate the Fed has: to support employment. During recent years the first of these two mandates, the fight against inflation, has dominated the other. This is a political choice that favors business and banks over workers. It gets interesting this year if unemployment keeps rising even while the economy starts to grow. The pressure to raise rates will increase as GDP ticks up. But such a move would damage the prospects for a fall in unemployment. Left wing politicians will want lower unemployment. Right wing politicians will want to limit inflation.

Whichever course the Fed chooses is thus political.

So just how independent can the Fed truthfully be?

Not so much.

Which is why opponents of opening up the Fed with a more transparent management style need to find a better defense than its purported independence.

Meanwhile … back at the regulatory ranch.

The Dodd legislation conforms fairly well with the House and administration proposals. I hear the the administration is even willing to support the establishment of FIRA, which they initially opposed.

Given the total opposition coming from the Republicans, I don’t see to much time being invested in a fruitless search for ‘bipartisan’ support for reform. Having been burned in the health care pseudo- debate, where bipartisanship was mocked by the actual discussions, I hope the administration and the Democratic leadership plunge onward without distraction.

This is not to say I wouldn’t support debate. Clearly on something this important we need healthy discussion. But I emphasize that word ‘healthy’. Name calling and obduracy are not healthy and don’t constitute debate. They are merely obstructionism and should be ignored.

Given the recent crisis and the evident failure of our laissez-faire system, we need to re-regulate finance. With the Dodd proposal now on the table the process has begun in earnest. I would like the Republicans to play a constructive role in getting the nation’s banking system safe again. If they join in the debate, then good. If not, well that’s just fine.

Either way we will get reform.

Good.

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