Senator Heller’s Pipe Dream: Fun With Deregulation

Nevada got hammered in the Housing Bubble.   Here’s what the Bubble looked like:

As the Housing Bubble collapsed so did Nevada employment. The graph looks like this:

Nevada lead the nation in home foreclosures for months on end, and it was only in January, 2012 that we were relieved to say “We’re Number Three.” [RGJ]    Why look backward?  Because in this instance the past is prologue. Lessons learned the hard way during the Savings and Loan Crisis of 1986 to 1995 were lost on bankers, builders, pundits, and politicians.

Risky Business

Does this sound familiar?  Deregulation of the Savings and Loans during the 1980′s gave the S&Ls many banking capabilities but without the regulations associated with banking.  Immediately after the deregulation of the Thrifts those that had state charters moved to federal charters because the latter were less restrictive. The states of California and Texas reduced their S&L oversight to match the federal deregulation.  The system rewarded risk. The greater the risk the greater the profits.  That is, the system was profitable until all the risky investments in real estate development started bottoming out.   The dominoes started to topple in 1985 when the Home State Savings Bank of Cincinnati, OH collapsed in March.    From 1986 to 1995 the number of Savings & Loan banks dropped from 3,234 to 1,645; and, the taxpayers were out about $124 billion dollars. [Link]

Deregulation and subsequent “innovation” in the last thirty years have given us the Savings and Loan Crisis (1986-1995), the Dot.Com Bubble from April 1997 to June 2003, [BI] the Enron Debacle and bankruptcy in December 2001, and the Mortgage Meltdown/Credit Crisis of 2008.

One would think we’d have learned something along the way, but here we have Senator Dean Heller (R-NV) touting his platform for economic growth:

“The key to turning our economy around is to remove impediments that have caused economic stagnation and the inability of businesses to create new jobs. Not continue with business as usual.”

“Dean believes that private capital, not the federal government, should be the primary source of mortgage financing for the housing market. Dean supports financial regulatory reforms that stop taxpayer-funded bailouts and address the growing liabilities of Fannie Mae and Freddie Mac.”

And, what might those impediments be? Might they be the Sarbanes-Oxley Act requiring accounting reforms and greater transparency in the wake of the Enron Debacle?  Might they be the provisions of the Dodd Frank Act, the most recent attempt to restrain some of the excesses of Wall Street during the Housing Bubble?  It’s well known Senator Heller joins his ultra-right wing cohort Senator Jim DeMint (R-SC) in proposing the repeal of the Dodd Frank Act.

“Dean supports financial regulatory reforms that stop taxpayer-funded bailouts and address the growing liabilities of Fannie Mae and Freddie Mac.”  What would those “reforms” be?  If you want to stop taxpayer funded bailouts of the banking sector, simply leave the Dodd Frank Act in place since it provides for an Orderly Liquidation Authority to wind down the next Lehman Brothers mess.   No one’s all that pleased with the mortgage twins BUT if they are put out of business, WHO picks up the action in the secondary mortgage market?  JPMorganChase? Barclays Capital?

The growing liabilities of Fannie Mae?  That might have been true in 2009 but it’s outdated information now. There’s home-made chart for that:

Data from Fannie Mae, Funding Summary and Debt Outstanding, PDF.

How about Freddie Mac? Again, Senator Heller’s talking points are behind the curve.  Here’s the portion of the presentation made by Freddie Mac to its investors in June 2012 (pdf) –

A bit of Fannie and Freddie bashing is always welcome in some financial sector circles, and usually gets some applause from stump speech audiences who don’t know any better, but trying to sell the idea that we can get out from under the risky business of deregulation, and increase economic growth by dismantling the regulatory frameworks enacted to at least prevent the financial sector from repeating its recent atrocious mistakes is a pipe dream of the first water.

Senator Heller is using the  message from the Frank Luntz GOP talking point memo on financial regulation, complete with the framing: “Public outrage about the bailout of banks and Wall Street is a simmering time bomb set to go off on Election Day,” Luntz wrote. “Frankly, the single best way to kill any legislation is to link it to the Big Bank Bailout.” (emphasis added)

Unfortunately, the facts and actual provisions don’t match the linkage.  New regulations seek to PREVENT the necessity of any more major bailouts by establishing the Orderly Liquidation Authority, but if Senator Heller can string “financial reform” + “bailout” into a single sentence, and then repeat the mis-characterization often enough,  then maybe someone who doesn’t know any better will believe him.

In short: If you liked the Savings and Loan Crisis, enjoyed the Dot.com Bubble bursting, cheered for Team Enron, and loved the Housing Bubble and Mortgage Meltdown…  Senator Heller is your kind of candidate!

Relevant Previous Posts: “Nibbling Away at Sarbanes Oxley,” DB March 26, 2012. “Deregulation Debacle,” DB June 27, 2012. “A good reason not to repeal Dodd Frank OLA,” DB October 22, 2011. “Full Tilt Boogie: GOP attempts to gut Dodd Frank,” DB November 7, 2012.

See also: “Investor Presentation, Freddie Mac” June 2012. (pdf)  Sam Stein, “Frank Luntz Pens memo to kill Financial Reform,” Huffington Post, April 3, 2010.

LIBOR suction

That sucking sound from across the Atlantic is the echo of Bob Diamond’s attempt at explaining why Barclays fiddled with the LIBOR, and what is now becoming a predictable litany of excuses from bankers as to why they are not accountable for the “culture of cynicism” which has given us Lehman Brothers, Bear Stearns, The Reserve Fund, and all those other dubious contributions to the history of the Great Recession of 2008.

Excuse Number One: “I didn’t know.”

Diamond: “He said he only learned the true extent of the scandal this month, and felt “physically ill” when reading incriminating emails from traders.”  [BBC]

Remember When?  Mr. Ken Lewis, CEO Bank of America was not advised of the state of Merrill Lynch’s Q4 report prior to advising the Board of BoA to accept the sales terms.  “Mr. Lewis was aware of no red flags suggesting the considered judgment of these professionals was was incorrect, based on inadequate information, or should be questioned for any reason.”  [ProPublica doc]

Rock meets hard place — either the handsomely compensated CEO is making the Big Bucks because he or she is managerial gold, capable of calm in the turbulent economic waters, willing to be accountable (after Sarbanes-Oxley) for financial policies and transactions, and a gifted hand on the rudder of the  corporate craft, OR the CEO is sadly isolated from the real news that should have made it through the corporate grapevine but was lost along the way among the multitudes?  So, which is it?  One can’t have the Buck Stopping Here only in good times.  However, it seems when the rains come the Buck is magically transformed into an eukaryotic cell replicating so quickly that there are enough bucks to scatter upon almost every desk in the firm.

There’s another problem with Mr. Diamond’s response. If he didn’t know “it,” then he didn’t “know it” for a very long time.  Consider this article from Bloomberg News May 29, 2008:

“Banks routinely misstated borrowing costs to the British Bankers’ Association to avoid the perception they faced difficulty raising funds as credit markets seized up, said Tim Bond, a strategist at Barclays Capital.

“The rates the banks were posting to the BBA became a little bit divorced from reality,” Bond, head of asset- allocation research in London, said in a Bloomberg Television interview. “We had one week in September where our treasurer, who takes his responsibilities pretty seriously, said: `right, I’ve had enough of this, I’m going to quote the right rates.’ All we got for our pains was a series of media articles saying that we were having difficulty financing.”  [Bloomberg] (emphasis added)

A strategist at Barclays Capital is quoted in an international news source in 2008 about LIBOR fiddling…and Mr. Diamond didn’t find out about it until 2012?  This must qualify for the slowest corporate grapevine in the history of corporate grapevines.   It’s a wonder how they ever get a birthday celebration together?

Excuse Number Two: “It’s just a few bad apples.”

Diamond: “He said that just 14 traders were to blame and that they had tainted the reputation of the 140,000 people who work for Barclays. He repeatedly stressed his “love” for the bank and its pride in what it has done.” [Guardian]

Remember When? “We had one person who was very earnest about what he had written, but 30,000 people who felt the opposite,” Blankfein said, referring to other Goldman employees, “and clients who were unbelievably supportive.” Lloyd Blankfein in response to an article about the culture at Goldman-Sachs. [HuffPo 2010]

It really doesn’t take very many apples to sour the barrel.  In this instance the unfortunate tale of Barings Bank and Nick Leeson should be recalled.  Barings was established in 1762, it had financed the Napoleonic Wars, the Erie Canal, and the Louisiana Purchase.  In 1995 it was gone, sunk beneath a £827 million really bad bet by trader Nick Leeson.   Yes, there were good people at Barings, but there was also the incredibly unlucky and evidently unsupervised Mr. Leeson.  Yes, there are good people at Barclays, but there are also the happy fingered people sending e-mails to one another like the following:

“Dude. I owe you big time!” wrote one trader to a submitter. “Come over one day after work and I’m opening a bottle of Bollinger.”  Another Barclays trader emailed a submitter: “If it’s not too late low 1m and 3m [rate] would be nice, but please feel free to say ‘no’…Coffees will be coming your way either way, just to say thank you for your help in the past few weeks”.  His friendly submitter responded: “Done…for you big boy.”  [IBT]

The Barclays correspondence is rather reminiscent of Kevin and Bob from Enron, remember Grandma Millie?

Kevin: So the rumor’s true? They’re [expletive] takin’ all the money back from you guys? All those money you guys stole from those poor grandmothers in California?

Bob: Yeah, Grandma Millie, man. But she’s the one who couldn’t figure out how to [expletive] vote on the butterfly ballot.

Kevin: Yeah, now she wants her [expletive] money back for all the power you’ve charged for [expletive] $250 a megawatt hour.  [NYT]

Steven Pearlstein described this culture in a 2010 business column:

“It’s been decades since the old investment and banking cultures gave way to a trading culture in which the driving principle behind every dollar traded or leveraged is to use whatever advantage you have to “rip the face” off some other trader, brag about it on the interoffice e-mail and take 20 percent off the top as a bonus. Raising and efficiently allocating capital for businesses and households are mere pretexts for a financial system that is now focused on reaping profits from high-frequency trading and sales of purely speculative instruments like synthetic CDOs.”

Mr. Pearlstein’s analysis could apply as easily to Barclays today as to Lehman Brothers not so long ago.   No, Wall Street and The City aren’t going to revert to the days when investment banking was a client based enterprise, not when trading is more profitable than capital allocation.  However, that doesn’t excuse unethical, dishonest, self-serving behavior even if the practices aren’t technically illegal.

Excuse Number Three: “It’s the regulator’s fault, they should have stopped us.”

Diamond: “Barclays had raised concerns with the regulators about other banks being involved, he said. “There was an issue out there and it should have been dealt with.” [Guardian]

Remember When?  The  Valukas Report came in on the Lehman Brothers debacle? (Especially in reference to Lehman’s risk controls.)

“The SEC did not know about the practice,” said Valukas in prepared testimony. “But it is difficult to understand why not. In the post-Enron world, it would be logical, if not obvious, to ask public companies to explain their off-balance sheet transactions. I saw nothing in my investigation to suggest that the SEC asked even the most fundamental questions that might have uncovered this practice.” [ProPublica]

Not that the SEC covered itself in glory, but it should be noted that the agency relied on Repo 105  reports that came from Lehman Bros. auditors.   Apologists flocked to the conclusion that if the SEC, or if the almost thoroughly captured OCC, or even the CFTC,  had ridden into the fray in 2007 all might have been set aright.  Yes, and we saw just how far that got CFTC chair Brooksley Born in 1999. [WaPo] The former CFTC chair certainly earned her “Cassandra” appellation, always to be right and never to be believed in time to prevent a catastrophe.

If Mr. Diamond is to earn his compensation on his way out of the Barclays premises in the City, then the least he could do would be to come up with some excuses and rationalizing that hasn’t already become hackneyed and common on Wall Street.

—————–

Background reading:  “Why I Am Leaving Goldman Sachs,” Greg Smith, New York Times, March 14, 2012.   Bank of America Merrill Lynch Suit Lewis Motion, Pro Publica, documents. Cora Currier, “How Bank of America Execs Hid Losses…,” Pro Publica, June 4, 2012.   Ray Fisman, “The Real Reason CEO Compensation Got Out Of Hand,” Slate, May 11, 2009.   Steven Pearlstein, “Wall Street’s know it alls can’t tell right from wrong,” Washington Post, April 23, 2010. Joris Luyendijk, “Barclays emails reveal a climate of fear and fierce tribal bonding…” Guardian, June 28, 2012.   Mary Shapiro, “Preventing Another Crisis…,” Investment News, March 25, 2012.   Finch & Gotkine, “Libor banks misstated rates,” Bloomberg News, May 29, 2008.

The Very Pat Answer To Every Question: Three Pillars of the Financialist Creed

One of the significant problems associated with Democrats is their propensity to get wonkish when policy questions arise.  Democrats quite often take policy questions seriously and thereby offer long answers to short questions while their Republican counterparts are busy repeating the Three Pillars of the Financialist Creed: Less Government, Less Taxation, and More Freedom.

The first two elements are easily decipherable. Less government means corporations are less regulated. A less regulated corporation has greater latitude to pollute the environment in manufacturing processes, and greater license to speculate in highly dubious investments.  The targets of sustained attacks by Congressional Republicans bear this out.  What have they set their sites upon? Two examples should suffice.

Consumer Financial Protection Bureau — The first wave of GOP attacks assaulted the Bureau as “unaccountable,” “too powerful,” and “didn’t solve Too Big To Fail.”  The second wave came from the House action to defund the agency. The third wave focused on crippling the agency by refusing to confirm a director. [Fiscal Times] The fourth wave comes as Republicans declare the recess appointment of Richard Cordray  unconstitutional.  [TPM] A fifth wave comes in as House Republicans complain that the agency will be too expensive. [Bloomberg]   Why attack the CFPB?

Why have there been five major waves of attack on an agency the mission statement of which says its job is: “To make markets for consumer financial products and services work for Americans by promoting transparency and consumer choice and preventing abusive and deceptive financial practices.” [Treas pdf] Don’t we want transparency? Consumer choice? And, the prevention of “abusive and deceptive financial practices?”  Yes, but the bankers want to “self-regulate,” and we saw where that got us in 2008.

The entire point being made by the Republican opponents of the Consumer Financial Protection Bureau is not about our freedom from deceptive, abusive, and predatory lending practices, but the license for the bank holding companies to devise and market any financial products they believe to be profitable in the short term.

The Environmental Protection Agency — Republican presidential candidates Rick Perry, Michele Bachmann, Ron Paul, Herman Cain, and Newt Gingrich have all called for the abolition of this agency.   However, when the Pew Center asked if environmental regulations cost too many jobs and hurt the economy only 39% of the general population respondents said yes, and only 22% of Republicans categorized as “Main Street” adherents replied in the affirmative.  [Pew pdf]  Given this gap between the positions taken by Republican leadership and the view of the general public, why would the GOP so diligently on the offensive about the EPA?

Why the emphasis on the alleged job-killing nature of regulation? “The dialogue between ‘jobs’ and ‘regulation’ is endless and repetitive, and in almost every instance, the claims by industry that new, more protective regulations would result in job losses and harm competitiveness have turned out to be dramatically overstated.” [Guardian] If the historical claims have been overblown, then why the perpetual hue and cry from conservatives?

The answer is that the American Petroleum Institute, the major oil companies, and the major chemical manufacturers would very much like to be free of government oversight and regulation.

This issue isn’t about our communities being free of air pollution, or the statistics concerning the incidence of childhood asthma declining in our cities and towns.  It isn’t about clean drinking water coming out of our taps, and the proper disposal and treatment of waste water.  It’s about the license given to major corporations to cut corners and save expenses in their production and manufacturing processes — again, in the short term.  The Republicans may bemoan the regulation of dry cleaning fluid disposal, but their bottom line corresponds more definitively with corporate quarterly earnings reports.

Lower taxes cure everything. Almost.  There’s a major exception to the general Republican rule.  It seems perfectly acceptable to allow increases in payroll taxes (those paid by most American workers) but not acceptable to raise taxes on millionaires and billionaires.  The Bush Administration tax cuts in 2001 and 2003 are demonstrably beneficial predominantly to those in the highest income brackets, yet the Republicans have strenuously objected to allowing these cuts to expire.

Republican arguments are framed as “taking your hard earned money out of your pocket to give to someone else,” but it appears to be quite acceptable to them that our pockets are picked while the millionaires and billionaires secure their wallets.   Lost in the deluge of rhetoric is the answer to a rather simple question — If lower rates of taxation are the panacea for everything that ails us, why when we have the lowest rates since the Eisenhower Administration are we not awash in jobs?

Republicans oppose increasing the taxation rate on carried interest but had difficulty supporting the extension of payroll tax reductions.  This should have been a dead give-away.  It’s not OUR taxes about which they are the most concerned.  WE pay increasing state and local levels of taxation to make up for cuts in federal spending.  WE pay payroll taxes and sales taxes, while the billionaires pay 15% on their hedge fund income.   We are told we can’t have nice things (Social Security, Medicare, a modern infrastructure) because we can’t “afford them.”  The response, of course, is that we could afford them if the billionaire financialists weren’t so firmly implanted in our government.

More freedom — to what?  We’re not “free” to take an affordable family vacation if the national parks have to close down on some days or raise the fees.  We’re not “free” to plan our retirement if we have to consider that the Social Security safety net might be privatized and added to the money Wall Street gets to play with in its casino.  We’re not “free” to shop for comprehensible and honest home loans if mortgage originators are given license to devise products that turn toxic with the first balloon payment.

We aren’t “free” from the impact of toxic waste disposal if the plant or mine upstream has license to dump whatever wherever.  We aren’t “free” to purchase products for our children and infants if we have to do our own chemical analysis to see if they contain toxic contaminants.  We aren’t “free” to make intelligent consumer purchases if we don’t have access to information about basic product safety.

We want the freedom to work. However, that doesn’t mean we want employers to have the license to demand that we labor in unsafe working conditions.  We want our high rise construction workers secure in their environs; we want our chemical workers safe from emissions. We don’t want to watch vigils of miner’s families while they wait for someone to be found alive, or not.

If our recent history is any guide, what we want is a capitalist system which rewards work, inspires entrepreneurship, and secures our futures.  What we could do without is the Financialist myopic vision of short term gains at the expense of long term economic growth, and quick revenue booked in the quarterly earnings reports at the expense of the American dream.

Entangling Alliances: Wall Street’s Self Interested Self Strangulating Financialism

When the Housing Bubble burst, and took the Nevada (US/World) economy down with it we saw the skeleton of a financial system laid bare in which our capital investment institutions were entangled by self interest and strangled by their own hands.  At the risk of redundancy, what we have as a result of thirty or so years of Wall Street ascendancy is NOT capitalism, but financialism; and it’s distorting our free market capitalist economy.

Lesson One: People Are Human.

Human beings have institutions.  We have organized our lives by creating religious, social, political, and economic institutions.  The word to be emphasized is WE.  We H. Sapiens are social animals.  We’d be offended if the word Troupe (a group of baboons) was applied to us, but nonetheless we obviously do organize ourselves in groups.  It’s handier for survival if we are grouped.  However, for all the sophistication of our grouping systems, we are still creatures who may act and react both rationally and emotionally.

One of the Great Myths we’ve accepted concerning our economic institutions is that Man is a Rational Animal, and therefore can individually behave in ways that maximize his or her personal self interest.  Upon this bit of soft sandstone we’ve constructed a free market economic system.

The problem with this assumption is that it’s been extended to say that Man is Always a Rational Animal.  We could make this claim but for thousands of years worth of panics, riots, mob scenes, witch-burnings, fads, and free-for-alls.  There was, for example, absolutely no self-advancing or protecting reason for the purchase of a Pet Rock — the brainstorm of a Los Gatos, CA advertising executive in the 1970s.  We bought them anyway.

When we seek to explain our economic institutions, we  need to remember that we’re also the people who  bought those pet rocks, sat on flagpoles, swallowed goldfish, consulted Ouija Boards, wore Raccoon Skin Caps, stuffed Volkswagens and telephone booths, and may purchase any product or endure any treatment promising to reverse the effects of aging or male pattern baldness.

Not to prolong or belabor the point about those $3.98 Pet Rocks, but we do need to recall that such things illustrate our “human” side, our capacity to act not only for our own interest, but also our capacity to behave as part of the crowd — “crowd” being a word we like much better than “troupe.”  When we behave this way it messes up our economic models.

Lesson Two:  We can be hoisted on our own assumptions.

Our technological innovations of the late 20th century created the capacity for us to trade various kinds of financial products in great quantities, and far faster than any previous generation, in our economic institutions.  Enter the Quants, mathematicians and statisticians who believed that they could create “models” by which risk could be reduced and profits could be made in voluminous trading…IF only we could prescribe the correct formula. There was a catch:

In finance, you can never reduce risk outright; you can only try to set up a market in which people who don’t want risk sell it to those who do. But in the CDO market, people used the Gaussian copula model to convince themselves they didn’t have any risk at all, when in fact they just didn’t have any risk 99 percent of the time. The other 1 percent of the time they blew up. Those explosions may have been rare, but they could destroy all previous gains, and then some.  [Salmon, Wired]

Formulaic answers always come with assumptions.  “If an automobile traveled at a rate of 30 miles per hour how long would it take to go 60 miles…?”  Color in the answer bubble for Two hours with your Number Two pencil — IF the driver (a) doesn’t stop for fuel, (b) doesn’t take time out to eat, (c) doesn’t find a road on which he can drive faster, (d) doesn’t get involved in a traffic accident … and so on and on.

Unfortunately, our formulaic models combined with our “human” behavior and the result was predictable if not pleasant:

“Everyone was pinning their hopes on house prices continuing to rise,” says Kai Gilkes of the credit research firm CreditSights, who spent 10 years working at ratings agencies. “When they stopped rising, pretty much everyone was caught on the wrong side, because the sensitivity to house prices was huge. And there was just no getting around it. Why didn’t rating agencies build in some cushion for this sensitivity to a house-price-depreciation scenario? Because if they had, they would have never rated a single mortgage-backed CDO.”

Bankers should have noted that very small changes in their underlying assumptions could result in very large changes in the correlation number. They also should have noticed that the results they were seeing were much less volatile than they should have been—which implied that the risk was being moved elsewhere. Where had the risk gone?   [Salmon, Wired](emphasis added)

The risk splattered all over our economic institutions.

Lesson Three: Human beings, as social animals, develop relationships.

The Rating Agency Relationships:

Why did “everyone” assume that housing prices would continue to rise? Why did no one question the statistical models?  Why didn’t the predictions that things could go wrong and go wrong very quickly resonate with decision makers in our economic institutions?

One perspective toward a response to these questions is that relationships formed which were self-serving if not self maximizing.

Why, for example, did the ratings agencies continue to rate CDO’s as “investment grade” after it became apparent in 2006 that the ratings were inaccurate?

“The Senate report says Moody’s and S&P knew as early as 2006 that high-risk mortgages were incurring a great deal of delinquencies and default, but the agencies continued to issue “investment grade ratings” on RMBS and CDO securities tied to risky mortgages for the next six months.” [HousingWire]

It doesn’t take much cogitation to conclude that the nature of the relationship between the investment institutions and the ratings agencies was predicated on an “issuer pays” model — so, investment houses went “shopping” for the highest ratings they could find.  Ratings agencies were incentivized to provide higher ratings in exchange for firm revenue.

Section 939A of the Dodd Frank Act strips the credit rating agencies clout, and partially answers the question from the Wall Street Journal “Who Elected The Ratings Agencies?”  The Dodd Frank Act also subjects credit rating agencies to “expert liability,” i.e. they would have the same liability for mistakes as accountants and advisers in bond sales, but the House Banking Committee in the 112th Congress wants to repeal this part. [Slate]

A large part of the problem with the ratings agencies is that we have not developed any other “system” to replace the relatively cheap ratings agency stamps of approval.

The Analysts Relationships:

Consider the following excerpt from Mike Mayo’s recent publication:

Analysts are supposed to be a check on the financial system—people who can wade through a company’s financials and tell investors what’s really going on. There are about 5,000 so-called sell-side analysts, about 5% of whom track the financial sector, serving as watchdogs over U.S. companies with combined market value of more than $15 trillion.

Mike Mayo told the Senate Banking Committee in 2002 that financial analysts “are on the front lines of holding corporations accountable.” However, he says, they haven’t always upheld this trust with investors.

Unfortunately, some are little more than cheerleaders—afraid of rocking the boat at their firms, afraid of alienating the companies they cover and drawing the wrath of their superiors. The proportion of sell ratings on Wall Street remains under 5%, even today, despite the fact that any first-year MBA student can tell you that 95% of the stocks cannot be winners. (emphasis added)

It wouldn’t take even a first year MBA student to figure out that 95% of all stocks won’t increase in value 100% of the time.  The following chart adds to the argument Mayo is making:

Only 4% of the total ratings indicate any reason to sell anything. Mayo’s area of expertise is in the banking sector, but his general observations might well be applied to any part of our financial realm when he describes what happened after he tried to warn investors about weaknesses in the financial sector:

After one meeting in New Jersey, one of the more senior portfolio managers offered to “advise” me about my views on the banking industry. The old-timer pulled me into a semidarkened room, just the two of us.

“I’ve been doing this a while,” he said, “and you’ve gotta know when to change your view. You can’t be so negative.” He probably meant it as kindly advice from someone who had been around the block, but it came across more like a disciplinarian father scolding his son. His argument seemed to be that as long as the stock prices were going up, the banks’ management and operating strategies didn’t matter.  [WSJ]

Lesson Four: The nature of relationships between and among our financial institutions is self-serving and not necessarily self-perpetuating.

We are human, and we’d like to survive.  Survival is sustained by being part of a group and groups form institutions for social, political, and economic purposes which help preserve US.  We are often rational, but sometimes we aren’t.  We make assumptions that can guide our behaviors, we can even make assumptions that allow us to make intelligent conjectures about the probability of future events.

However, when the financial system is so distorted that short term profits  become of greater importance than the overall viability of our economy we’re in trouble.

The relationships themselves are problematic.  The analyst who issues a “sell” recommendation will irk the Bond Division which is trying to get business from the corporation, and the Equities Division which is trying to get business for a IPO?  And, the CEOs whose compensation packages are well stuffed with stock options?  The ratings agency which calls attention to the fact that the CBO in question is a toxic mass of formulaic jibberish won’t get paid by the issuer. The current system provides motivation for short term gains at the expense of long term losses.

Not to put too fine a point to it, but we have a system in which individual short term gains take precedence over the elements and activities which produce long term stability and economic safety, i.e. Financialism.   Without independent analysis and individual/corporate accountability for performing the self-serving before the self-sustaining, we are asking for trouble in the shape of future excessive volatility and economic disasters.

The good news is that as human beings, we are quite often rational, and there is always the hope we can “figure a way out of this.”  We just have to find a way to clear the debris off the tracks.

Amazing Amounts of Mis-Information: The Deregulation – Debacle Cycle

All it takes is just a few hours trapped in a motor vehicle traveling over some of Nevada’s miles and miles and miles of little except miles and miles and miles, with a radio (right wing/left wing) to hear some of the most amazing mis-information available for one’s entertainment — if not for one’s edification.  Most of this stuff happens during discussions of (1) economics, (2) history, or the worst possible combination… (3) economic history.

Mush-o-nomics

“Mush-o-nomics” happens when commentators, pundits, and others attempting to speak in Economic Tongues start “explaining” the ramifications of economic policy legislation.

##  One such piece of legislation is the Gramm-Leach-Bliley Act of 1999.  The act was supposed to “modernize” financial services.  Modernization was to be accomplished by repealing the 1933 Glass Steagall Act which mandated the separation of retail/commercial and investment banking.

“As a collective reaction to one of the worst financial crises at the time, the GSA (Glass Steagall Act) set up a regulatory firewall between commercial and investment bank activities, both of which were curbed and controlled. Banks were given a year to decide on whether they would specialize in commercial or in investment banking. Only 10% of commercial banks’ total income could stem from securities; however, an exception allowed commercial banks to underwrite government-issued bonds. Financial giants at the time such as JP Morgan and Company, which were seen as part of the problem, were directly targeted and forced to cut their services and, hence, a main source of their income. By creating this barrier, the GSA was aiming to prevent the banks’ use of deposits in the case of a failed underwriting job.” [Investopedia]

Those members of the Quick Fix contingent who see the Era of Glass Steagall as  a golden time with no economic or banking problems are forgetting that the “Wall” didn’t serve to prevent some of the more egregious practices invented by Wall Street and the financial community between 1933 and 1999, nor did it prevent recessions.

It did not, for example prevent the Recession in 1945 as the U.S demobilized from World War II and landed in what could technically be judged a “post war recession,” because of the profound decline in the GDP.   Nor did Glass Steagall prevent the Federal Reserve from flexing its muscles after the Korean War, and tightening the money supply out of fears of higher rates of inflation — it turned out that inflation wasn’t the problem, and in 1953 and 1958 the U.S. dropped into another recession.

Nor could Glass Steagall prevent OPEC from quadrupling its prices in 1973 sending the U.S. economy spinning downward, with the GDP declining about 3.2%.   There was nothing the provisions of Glass Steagall could do in 1980 to prevent a market reaction to the Iranian Revolution, and the consequent tightening of U.S. monetary policy which prevented inflation, but also prevented economic growth.

We also can’t assume that the enforcement of Glass Steagall would have prevented the Savings and Loan Crisis of the 1980′s.   While there are parallels between the actions of JP Morgan in the 1920′s and the inventiveness of Goldman Sachs in the 2000′s, there are even more comparisons to be drawn from the behavior of financial institutions between 1980 and 1989 and the behavior of their modern investment house descendants from 1999 to 2008.

Looking Backward: The Savings and Loan Debacle

De-Regulation:  The impetus for de-regulation comes when there is more emphasis placed on the profitability of the banking or financial firms than on the efficient accumulation and distribution of capital.  The theoretical argument is often made that the financial firms will be more profitable because they can be more efficient, and it will be obvious they are more efficient because they are more profitable.  The tautology makes for great quips and quotes — but, it really doesn’t describe economic reality.

For instance, consider what happened after deregulation and additional statutory powers enacted between 1980 and 1982 enabled the Saving and Loan sector to expand their lending capability, take the cap off their deposit interest rates, take advantage of tax incentives for housing loans (Tax Reform Act of 1981), and then as of September 1981 satisfy capital requirements by issuing “income capital certificates” to be purchased by the FSLIC — the S&L didn’t really need to be solvent if it could paper over its solvency problems with the “ICC’s.” [FDIC]

The FDIC chronology describes what happened between 1982 and 1985:

“Reductions in the Bank Board’s regulatory and supervisory staff. In 1983, a starting S&L examiner is paid $14,000 a year. The average examiner has only two years on the job. Examiner salaries are paid through OMB, not the Bank Board. During this period of supervisory and examination retraction, industry growth increases. Industry assets increase by 56% between 1982 and 1985. 40 Texas S&Ls triple in size between 1982 and 1986; many of them grow by 100% each year. California S&Ls follow a similar pattern.”

Debacle:  Sound familiar?  By March, 1983, it’s apparent to FHLB Chairman Edwin Gray that the deregulation has gone too far, and he begins to tighten the reins on the S&L industry.  This won’t prevent the demise of a Mesquite, TX Savings and Loan, the first casualty in 1984.  Nor did this stop the Ohio Savings and Loan “Bank Holiday” in March, 1985, nor the failure of six more S&Ls in Maryland in May 1985.  Someone might have wanted to stop the train at this point, but policy decisions made between 1985 and 1987 didn’t prevent the derailment.

Enter the bailouts:

“August, 1987–Competitive Equality Banking Act of 1987 enacted. The Act authorizes $10.8 billion recapitalization of the FSLIC with only $3.75 billion authorized in any 12-month period. Also contains forbearance measures designed to postpone or prevent S&L closures.

February, 1988–Bank Board introduces the “Southwest Plan” to consolidate and package insolvent Texas S&Ls and sell them to the highest bidder. The strategy is to resolve insolvencies quickly while conserving scarce cash for FSLIC. The Bank Board uses a number of strategies to pay for the difference between assets and liabilities of the failed institutions: FSLIC notes, tax incentives, and income, capital value and yield guarantees. The Bank Board disposes of 205 S&Ls through the Southwest Plan with assets of $101 billion. ” [FDIC]

And, then came the Big Bailout:

1989–President Bush unveils S&L bailout plan in February. In August, Financial Institutions Reform Recovery and Enforcement Act (FIRREA). FIRREA abolishes the Federal Home Loan Bank Board and FSLIC, switches S&L regulation to newly created Office of Thrift Supervision. Deposit insurance function shifted to the FDIC. A new entity, the Resolution Trust Corporation is created to resolve the insolvent S&Ls.

Other major provisions of FIRREA include: $50 billion of new borrowing authority, with most financed from general revenues and the industry; meaningful net worth requirements and regulation by the OTS and FDIC; allocation funds to the Justice Department to help finance prosecution of S&L crimes. Additional bank crime legislation the next year (i.e., the Crime Control Act of 1990) mandates a study by the National Commission on Financial Institution Reform, Recovery and Enforcement to uncover the causes of the S&L crisis, and come up with recommendations to prevent future debacles. [FDIC]

In short, what we get when we de-regulate a sector of finance and banking in the interest of improving profitability rather than to facilitate the efficient flow of capital investment is A Big Bubble, A Big Deflated Bubble, and a Bail-out — in that order.

Insofar as the repeal of Glass Steagall was an act of de-regulation, then we might say that the repeal fits the pattern.  However, the best argument for the enforcement of the Volker Rule is not that it re-establishes Glass Steagall, but that it restores a measure of regulation to a sector of the economy which has an unfortunate track record of behaving badly when no one is looking, and of inflating more bubbles more quickly than the helium tank at the local party store can fill balloons.

Derivative Debacle

If one comparison seems a bale short of a full load, we can refer back to the de-regulation of the commodity (and hence derivatives) market beginning with calls for “modernization” in 1999.   In October 1999, William Rainer, newly seated chair of the Commodity Futures Trading Commission announced his intention to de-regulate the industry.

“Rainer, speaking to the Chicago-Kent College of Law derivatives and commodities law institute, said the CFTC “intends to withdraw from approving contract designations and will soon issue proposed regulations to permit exchanges to adopt new rules without prior approval.”

He said the agency will move from being a “front-line to an oversight” regulator as the CFTC first turns to a “major deregulation” of the financial futures market, beginning with those that compete with over-the-counter derivatives.”  [Chicago Trib 1999]

Former CFTC regulator Brooksley Born played Cassandra to Rainer’s enthusiasm.

“A little more than a decade ago, Born foresaw a financial cataclysm, accurately predicting that exotic investments known as over-the-counter derivatives could play a crucial role in a crisis much like the one now convulsing America. Her efforts to stop that from happening ran afoul of some of the most influential men in Washington, men with names like Greenspan and Levitt and Rubin and Summers — the same Larry Summers who is now a key economic adviser to President Obama.

She was the head of a tiny government agency who wanted to regulate the derivatives. They were the men who stopped her.

The same class of derivatives that preoccupied Born — including the now-infamous “credit-default swaps” — have been blamed for accelerating last fall’s financial implosion. But from 1996 to 1999, when Born was the chairman of the Commodity Futures Trading Commission, the U.S. economy was roaring and she was getting nowhere with predictions of doom.”  [WaPo 2009]

We know the rest of the story.  Ranier’s de-regulation continued apace, Greenspan et. al. were convinced the Invisible Hand of the Great Free Market would be sufficient to curb the excessive exuberance of the traders — and the whole construct, already failing in 2007,  collapsed in a heap in September 2008.

Before we can hope to re-regulate the machinations of Wall Street and the dubious enthusiasms of financial institutions and the traders who function therein, we need to agree that there is a “public utility” aspect to our financial system, and that the ultimate  intention of all subsequent legislation is to facilitate the efficient flow of capital — not the maximization of profits.