Thoughts on Financial System Reform and American Leadership

Economic Donkeys, by former IMF chief economist Simon Johnson ("The Quiet Coup") and Peter Boone, head of the Effective Intervention charity, lays out a persuasive case for what should be done with Big Finance. Please read the entire piece. Here are excerpts:

Today, a year after global financial collapse and the ensuing tragedy for millions, our economic leaders are lining us up to suffer again (and again) through the same horrible experiences.

Today Lehman’s senior debt trades at a mere 10 cents on the dollar, suggesting its $600 billion in assets were a mirage. This outcome is even more startling when compared to senior debt at Kazakhstan’s defaulting large banks, where management is now accused of serious malfeasance, yet that debt trades at 20 cents on the dollar – twice the price of Lehman’s debt.

At the G20 meeting of finance ministers last week, political leaders united behind two key steps which they claim will “prevent another Lehman”: tighter controls on the pay of executives and more capital for banks. France and Germany blame the crisis on lax regulation in Anglo-Saxon markets and excessive pay packets that encourage irresponsible risk taking. The British and Americans counter that European banks have too much debt (i.e., in the jargon, are “overly leveraged”), and need to raise more capital. The final communiqué proposes to do both, and we will hear more of the same at the upcoming G20 heads of government summit in Pittsburgh. But, in reality, both sides want only minor adjustments that cannot solve the real problems posed by our financial system.

Tim Geithner, now US Treasury Secretary, is pushing for higher capital requirements for banks, i.e., they need to have more shareholder funds to protect against future losses. But he surely knows that two weeks prior to its bankruptcy, Lehman’s management reported they were well-capitalized, with a tier one capital ratio of 11% — roughly twice what the United States currently considers is needed for a well-capitalized bank, and much higher than the American side is proposing in private conversations.

The pre-crisis activities and portfolios of Barclays, Goldman Sachs, and other “survivors” of this crisis were only slightly different from Lehman Brothers or Bear Stearns, which failed. The “good” banks also securitized subprime assets, helped build the intricate web of IOUs between banks and insurance companies, and leveraged their balance sheets to enormous levels. The winners were not better, they were just smart enough to make sure someone else held the bad assets when the music stopped, and they were powerful enough to win generous bailout packages from their governments.

The danger we face is that, by bailing out these institutions and rewarding failed managers with new powerful positions, we have now created a much more dangerous financial system. The politically well-connected, knowing they will most likely do fine in the next crisis, is now highly incentivized to take even greater risk.

Once we admit this profound problem in our system, we can begin to think of the radical measures needed to solve it. There is no doubt these solutions will include much greater capital requirements, so that bank shareholders know that they face substantial losses if their ventures fail.

But, we also need to ensure that our regulators are not captured by the banks that they are meant to oversee. This means we need to put checks on financial donations to political parties, and we need to buttress our regulators with more intellectual firepower and financial resources, along with rules that ensure independence, in order to be sure they can act in the interests of the broader population.

We also need to close the revolving door, through which politicians and regulators leave office to earn their nest eggs in finance, and “financial experts” move directly from failing banks to designing bailout packages. The conflicts of interest are abundant and most dangerous.

Last week the UK’s chief financial regulator, Adair Turner, faced heavy criticism from the City, Chancellor Darling, Boris Johnson, and editorials in the Financial Times and Wall Street Journal. His main offense was daring to raise the issue of whether parts of our financial system have become socially dysfunctional, in an interview with Prospect Magazine. He called for greater capital requirements at banks, and he pondered how it would be possible for regulators to preserve the valuable parts of our financial system, while ensuring that regulation limited the harmful parts. These are eminently sensible questions which anyone with a public spirit should understand are critical policy issues today.

Sadly, these public rebukes to Lord Turner are a further indication that very few of our leaders are prepared to even discuss the real problem, let alone seek a sufficient solution.

DoctoRx here.

I believe that the United States and the world need personal leadership from President Obama on this issue.

While 30+ million U. S. citizens lack health insurance (millions of whom are eligible for programs such as Medicaid but have not joined) but by law do have access to emergency treatment is an important issue, the current (receding?) economic depression and financial crisis affects us all. Why the overwhelming emphasis on health insurance but not on a risky financial system that has been estimated to have cost $23.7 trillion in direct governmental expenditures and guarantees? (Estimate by Special Inspector General for TARP Barofsky)

Sadly, the President may be "distracted" from financial reform efforts by the effort to aid less than 10% of all Americans in obtaining health insurance. The job is indeed demanding, but he asked for it!

As the Johnson/Boone essay argues, the entire world needs enlightened American leadership to help build a stronger financial and banking system. It needed it from Barack Obama beginning the day he won the election. Nearly one year later, this leadership remains to too great a degree missing in action.

Copyright (C) Long Lake LLC 2009

Dropping the Bull

Things are seldom what they seem;
Skim milk masquerades as cream . . .

Black sheep dwell in every fold;
All that glitters is not gold;
Storks turn out to be but logs;
Bulls are but inflated frogs . . .

Gild the farthing if you will;
Yet it is a farthing still.

- From "Things Are Seldom What They Seem", Gilbert and Sullivan, HMS Pinafore, 1878

Here are several bits of news either reported, or in one case seen by me in the past 48 hours alone:

Bank of America Accused in Ponzi Lawsuit

By LESLIE WAYNE
Published: March 27, 2009

Bank of America effectively set up a branch in a Long Island office that helped Nicholas Cosmo carry out a $380 million Ponzi scheme, according to a class-action lawsuit filed in federal court.

The lawsuit, filed in Federal District Court in Brooklyn late Thursday, contends that Bank of America “established, equipped and staffed” a branch office in the headquarters of Mr. Cosmo’s firm, Agape Merchant Advance. As a result, the lawsuit contends that the bank knowingly “assisted, facilitated and furthered” Mr. Cosmo’s fraudulent scheme.

“Bank of America was at the epicenter of this scheme,” said the lawsuit, which seeks $400 million in damages from the bank and other defendants. “Without Bank of America’s participation, the scheme would not have succeeded and grown to such an enormous size.”

Mr. Cosmo surrendered to authorities at a Long Island train station in January in connection with a suspected Ponzi scheme involving what Mr. Cosmo called “private bridge loans” that promised investors returns of 48 percent to 80 percent a year. Many of his 1,500 investors were blue-collar workers and civil servants.

DoctoRx here. Could this be a nuisance suit? Could it be an Enron moment? We'll see. Next, from the Zero Hedge blog:

Merrill Traders Mismarked P&Ls By Up To $7 Billion To Game Bonus

We are surprised to have missed this the first time around. On page 4 of the Cuomo accusations against Merrill (and Lewis), the Attorney General raises a huge allegation against Merrill's trader employees: the AG claims that traders "willfully" manipulated their P&Ls, potentially by up to $7 billion, in order to make it seem they were more profitable in advance of the early mid-December bonus evaluation, knowing full well they would subsequently remark their books lower, having been already paid for the previous fake P&L number.


(From the complaint): The Office has also learned that, less than a week after Merrill voted its premature bonuses, Merrill determined that it would incur an unexpected additional $7 billion in losses for the fourth quarter of 2008, beyond the $8 billion it was already anticipating (Id. at Ex. D at 9-11 and Ex. H at 128-29). It appears that some of these losses may have been booked by Merrill employees who marked down their portfolios only after their 2008 bonuses were set (Id. at Ex. W). Despite the gargantuan unexpected losses, Merrill did not reconsider its bonus awards (which had been voted but not yet paid out) and Bank of America neither requested nor demanded that Merrill reduce its bonus pool (!d. at Ex. C at 106-07, Ex. D at 115-17, Ex. E at 86, and Ex. H at 28). Again, these material developments were undisclosed to the company's shareholders or to the legislators considering how to salvage the American banking system (!d. at Ex. C at 146-49).

(Back to Zero Hedge): As any derivatives trader will attest, this calendar "straddle" as it is lovingly called by some, is by far the oldest trick in the book, where multivariate models' inputs are jiggered in order to spew one number, only to have the correction subsequently "discovered" and fixed at the bank's expense while the bonus has already been pocketed. It is also a reason why many banks have pushed their bonus determination late into the subsequent year so that they are able to have at least semi-audited numbers serve as the basis for bonuses.

If Cuomo pursues this avenue successfully and obtains proof of malfeasance, the consequences would be much more dire than a mere slap on the wrist and bonus disgorgement, as mark manipulation does have criminal connotations associated with it, for both the perpetrator and the enabler/supervisor (emph added).

DoctoRx here. Is Attorney General Cuomo engaging in a frivolous pursuit? Next:

From Naked Capitalism:

We're not quite as healthy as we thought we were. Oops. (WSJ)

J.P. Morgan Chase Chief Executive James Dimon said...that March was a little tougher than the first two months of the year....Bank of America...CEO Kenneth Lewis also said that March had been a tougher month for his bank. [Convenient that they dumped this on Friday afternoon, and at the close of a very good week].Readers may recall that a few weeks ago, Dimon and Lewis---along with Citi's Vikram Pandit---said the first two months of the year had been very good:

Pandit, March 10th: “We are profitable through the first two months of 2009 and are having our best quarter-to-date performance since the third quarter of 2007.”

Dimon, March 11th: "Jamie Dimon, the chief executive of JPMorgan Chase, said Wednesday that the bank was profitable in January and February..."

Lewis, March 12th: "We have been profitable for the first two months of the year,” Lewis told reporters after a speech in Boston today.

DoctoRx here. All investors recall that twice last year, the SEC arbitrarily squeezed the short-sellers by putting in selective restrictions on short sales of financial companies. The second of these was so blatant a form of market manipulation that such "financials" as IBM were included in the ban. What happened a few weeks ago was in relation to the Geithner bail-out and goosed the stocks big-time. Now, also in March, we get the real news. The truth is that banking is a poor business now, with the (important) exception that the Fed is doing everything it can to keep the banks enjoying a huge net interest margin. More stock market manipulation.

Next, more on the legal front, again from Zero Hedge:

Cuomo Pitting Thain vs. Lewis: One of Them Will be in Big (Legal) Trouble

Turns out NY AG Andrew Cuomo is pretty smart: he is seeking a court order that will force John Thain to testify as to what really happened in early December when Merrill bonuses were paid out ahead of posting a huge loss, or otherwise he will hold the former Merrill chief in contempt and possible further legal escalation.

Thain has claimed he is worried he would be sued by BofA (BAC) if he does talk to Cuomo, so the fan of gold-plated commodes is between a rock and very angry attorney general. Cuomo's strategy is likely to catch Lewis in perjury, since the BofA boss claimed in congress - on the record - that he had no control over the whole Merrill bonus fiasco.

Gasparino reports that BofA HR chief Andrew Smith in fact had full supervision and control over who gets what among the top 15 people at Merrill, meaning that Lewis could be in very hot water here.


Back to DoctoRx. We will see. Next, the biggest banking recipients of bailouts apparently are carrying securitized mortgages at very high prices on their balance sheets (courtesy of a recent analysis by Goldman, Sachs) while simultaneously buying similar securities at much lower prices. Assuming this is true, it is doubly galling, because the cover story for all these bailouts is that taxpayers need to give these companies money so the companies can turn around and lend us back that money. Why are they buying securities at all; don't they have enough? (The truth is that in a poor economy, banks mostly want to lend to people or companies who are financially strong enough that they do not need to borrow.) From the New York Post:


DOUBLE-DIPPERS
CITI, BOFA BUYING BACK LAUNDERED LOANS AT LOWER RATES

. . . the banks' purchase of so-called AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows among even the most seasoned traders. Alt-A and option ARM loans have widely been seen as the next mortgage type to see increases in defaults.

Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.

DoctoRx again. Next, commentary from the $80 Billion hedge fund, Bridgewater, which admits that the latest bank bailout plan is a rip-off:

Hedge fund Bridgewater mulls U.S toxic asset plan

NEW YORK (Reuters) - Bridgewater Associates Inc, one of the world's biggest hedge-fund managers, said on Tuesday it might be interested in participating in the U.S. Treasury's public-private investment program, calling it a "big transfer of money from the government to the banks and to the buyers."

. . . Bridgewater said: "From a macro perspective, this is a big transfer of money from the government to the banks (who are getting the higher prices for their assets) and to the buyers (who are probably going to get a heck of a deal because of the non-recourse loan and the easy access to leverage).

"If the government was operating in an economic way, it would not do this deal -- it would deal with the banks' finances separately and sell this insurance (i.e. the implied put arising from the non-recourse loan) for what it's worth," Bridgewater said in the letter.

DoctoRx here. Finally, just in case you were under any illusion that anything material is changing for the better anywhere in the financial system, comes this news from the WSJ:

Risk Officers Remain at Insurer's Helm

Inside American International Group Inc., a group of top executives called the Credit Risk Committee oversaw some of the company's biggest bets, such as the insurer's foray into credit-default swaps.

But even after a $173 billion government bailout, this group, which reviewed and approved risk-taking decisions, remains largely unchanged. At least five of the 10 committee members have served for years, according to internal company documents. Some served as far back as 2003 and 2004, the documents show.

Even amid change at AIG, much of the company's day-to-day infrastructure remains in place.


DoctoRx with final comments. There's an unending stream now of this sort of stuff. Not to forget that Bernard Madoff was one of the founders of NASDAQ, which for years has existed almost solely to transfer money from investors and speculators to corporate insiders and the financial community writ large.

World trade is collapsing, perhaps faster than in the Great Depression. The net worth of individuals is down 20% year on year, also rivaling that of the Depression (when fewer people owned stocks or homes). At least four experts on financial/economic crises in emerging nations liken the U. S. to these countries. These experts are:

Ken Rogoff, former Chief Economist to the IMF; now Professor at Harvard;
Simon Johnson, former Chief Economist to the IMF; now Professor at MIT;
Nouriel Roubini, former adviser to U. S. Treasury Department under Clinton/Summers; now (as before) Professor at NYU Stern School of Business;
and Desmond Lachman, with prior senior roles at IMF and then investment banking.

Looking at the current news items, how can these serious people easily be rebutted?


Copyright (C) Long Lake LLC 2009

The Intelligentsia Opines: U. S. as Russia-tina

Two recent articles have surfaced, each written by former IMF economists, one of whom is also an MIT professor and the other of whom has spent time with Big Finance, each comparing the U. S. to such countries as Argentina or Russia during their various economic crises. Here are links to each with small snippets. The first of these is very well written and easily digested in one sitting.

From "The Quiet Coup", by Dr. Simon Johnson (published by The Atlantic Monthly)

(Intro): The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time. . .

Becoming a Banana Republic
In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). . .

From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man).

Similarly, Desmond Lachman pens "Re-Emerging as an Emerging Market" (Washington Post), which begins:

Back in the spring of 1998, when Boris Yeltsin was still at Russia's helm, I led a group of global investors to Moscow to find out firsthand where the Russian economy was headed. My long career with the International Monetary Fund and on Wall Street had taken me to "emerging markets" throughout Asia, Eastern Europe and Latin America, and I thought I'd seen it all. Yet I still recall the shock I felt at a meeting in Russia's dingy Ministry of Finance, where I finally realized how a handful of young oligarchs were bringing Russia's economy to ruin in the pursuit of their own selfish interests, despite the supposed brilliance of Anatoly Chubais, Russia's economic czar at the time.

At the time, I could not imagine that anything remotely similar could happen in the United States. Indeed, I shared the American conceit that most emerging-market nations had poorly developed institutions and would do well to emulate Washington and Wall Street. These days, though, I'm hardly so confident. Many economists and analysts are worrying that the United States might go the way of Japan, which suffered a "lost decade" after its own real estate market fell apart in the early 1990s. But I'm more concerned that the United States is coming to resemble Argentina, Russia and other so-called emerging markets, both in what led us to the crisis, and in how we're trying to fix it.

Finally, another Obama supporter (gingerly) criticizes him for his latest bail-out plan, in a Naked Capitalism post:

Guest Post: The new bailouts are an end-run around Congress

Submitted by Edward Harrison of the site Credit Writedowns

Edward Harrison here. What follows is a post I wrote for Credit Writedowns last night. Before I present the post, I want to make a few editorial comments, however.

First, for full disclosure, I support Barack Obama. I voted for him, campaigned for him and contributed to his run for office. I am happy to see him as President.

Nevertheless, he is now making policy that affects us all. As a blogger, I am required to show some objectivity in analyzing his policy decisions. I am not altogether content with that policy and my articles do reflect this.

The Harrison article is a bit lengthy and thinly edited. It presents the Obama-Geithner bank bailout plan in the context of another end-run around Congress, namely the 1995 Mexico bailout engineered by Treasury and the IMF; the legality of the current plan is questioned. It is presented here because it documents the continued flow of Obama supporters who have seen that his policies toward Big Finance are essentially those of George W. Bush, and have begun to criticize him by name. This continuity of policy has been emphasized by this blog since its founding. I continue to believe that Mr. Geithner belongs elsewhere, and should be replaced by someone more adversarial to large complex financial institutions.


Copyright (C) Long Lake LLC 2009

Serfing USA

As the stock market parties as though the bear market has ended, it's good to keep track of various facts.

An update on mortgage equity can be found at Calculated Risk's post, "Fed: Household Wealth Cliff Dives in Q4", from which the following is reported and calculated:

In 1952, despite all the tough economic times the country had been through, the average homeowner had 80% of the value in his (her) home as equity, the rest being debt. That percentage stayed as high as 70% as late as 1985. It is now 43%.

Based on various other statistics, I calculate that the homeowners who have mortgages only have at most 18% of the value of their homes as equity, the rest being debt (mortgage(s)).

Worse, for them to realize money from their homes, they will face commissions and other closing costs of (say) 8%. So for the about 70% of homeowners who do not own their home free and clear, if they sell, they will receive almost none of the value of the house.

Thus, the forces that control this economy have seen to it that most homeowners are financial serfs.

Next, on the same debt/credit axis, the Labor Department reported that corporate debt rose at a 2.2% annual rate. (One wonders why it rose at all in a severe economic downturn, and who lent the funds). However, total nonfinancial debt rose at a 6.3% annual rate in Q4 2008 (after rising 8.1% in Q3). Why so much increase in debt? Because the Federal government raised its debt issuance by 37% (following an increase of 39% in Q3), that's why.

Thus, all the talk in the media about "deleveraging" misses the more major point. Yes, it is true that Goldman, Sachs and Morgan, Stanley can now control fewer assets per borrowed dollar. That is a form of deleveraging. The more major form of leverage is debt itself. The Merchants of Debt, led by the Federal Reserve and the Federal Government, with their favored industry of finance, continue to grow. "Reform" is likely to simply mean a greater presence for the Feds, but with institutionalization of the toxic derivatives such as credit default swaps that Nassim Taleb correctly inveighs against rather than the banning of them.

The large financial institutions are being rapidly recapitalized by such maneuvers as putting Federal money into the vehicles of AIG and Fannie and Freddie, which are losing vast sums on derivatives. Since it is in the nature of derivatives that there is generally a winner for every loser, you can be sure that the winners are the politically favored large complex financial institutions all over the globe. This why Simon Johnson (former chief economist of the IMF and now a professor at MIT) in "Business as Usual", reports that:

If you think that the power of the banking industry may be in decline, or that its leaders are humbled, or that any kind of major change is underway, please review carefully Jamie Dimon’s speech from Wednesday, March 11 (available on Bloomberg.com).

Mr. Dimon, who runs JP Morgan Chase, makes it clear that he has great respect and appreciation for all that Hank Paulson did for the financial sector. He also strongly implies that it is time for the government to stop worrying about what approach to adopt; as far as he is concerned, the time for wrangling and figuring out what went wrong is over and the time for really big transfers of taxpayer value is now.

There is no sense here that anything much has changed. Sure, we’ve lost some banks, we’re in a big recession, and everything we thought sensible for banks in terms of regulation/risk management/corporate governance lies in tatters. But it is obvious, from the words, tone, and body language of Mr. Dimon that he thinks his side has won and it is back to business as usual, albeit now with a somewhat larger market share. On all of this, he probably has inside information.

Considering all the above, it may be that the financial industry is simply consolidating and expanding its hard-won gains and that these gains will be ratified by governments that also like playing the game, while the once-backbone of America- the homesteader/homeowner- is reduced to virtual peonage.

This is change, but not one that ordinary citizens believe in.

Copyright (C) Long Lake LLC 2009