It’s about time for those who truly believe in free market Capitalism to stand upright and bellow: Who’s going to Save Our System? For those who haven’t been following this blog recently perhaps a bit of background is in order.
A Brief History
What we all learned in high school business or economics classes, or received from college Econ 101, was that free market capitalism requires that investment capital move from areas of surplus to areas of shortage. That’s the entire point of our financial sector — if one believes in free market capitalism. Money moves within the private sector from those who have savings to invest to those who wish to sell shares of their corporations (equities) , or to those who wish to borrow funds (bonds).
Unfortunately, the system has been hijacked by those Financialists who make their money by applying some creative accounting, combining a large dose of leverage legerdemain, and adding in a whopping portion of complex derivative instruments, in order to create a system in which they make that money by speculating on risk. This is a toxic brew. Capitalism thrives on stability. Financialism* encourages volatility. Capitalism depends upon the investment of capital. Financialism requires speculation with capital.
Every dollar expended speculating on complex derivatives with no connection to the basic transactions involving capital transfers or commodities is a dollar unavailable for small business loans, for investment in equities, for student loans, for car loans, for consumer loans, for the sale of corporate bonds, for venture capital investment in new businesses.
The FDIC warned us as early as March 2003 that when banks shift from focusing on capitalism to financialism things can get very uncomfortable:
“Derivatives activity at commercial banks, as measured by total notional values of over $56 trillion as of December 31, 2002, continues to grow dramatically. Derivatives serve an essential role in the U.S. and world economies but also present certain risks to the deposit insurance funds. “
And how do we know these risks are an essentially speculative activity? Again, from the FDIC in 2003:
‘While the notional amount is a proxy for the amount of derivatives activity, it does not measure the riskiness of the activity. The notional amount itself is seldom at risk of loss with derivatives. Instead the derivatives investor is at risk of loss from changes in prices of or rates earned on the physical or financial assets that the notional amount represents.”
Translation: If the basics of the transaction are malleable, like a bunch of mortgages warehoused in some off -shore account and then sliced, diced, and recombined into those infamous CDO’s then the investor is at risk when the prices change. What are the prices based on? For the most part they were “Mark to Mythology.” Those CDO prices and the various derivatives therefrom were priced at whatever the market said they were… and when The Almighty Financial Market says they are worthless we get Bear Stearns, Lehman Brothers, and a lovely crash in late 2008. We’ve seen this movie and it didn’t end well.
When the dust settled and the Financial Crisis Inquiry Commission completed its report in 2011, several points were made very clear:
(1) There were colossal failures of bank and investment house risk management.
(2) A combination of excessive borrowing, risky investment, and a lack of transparency put our financial system on a collision course with disaster.
(3) Regulatory agencies were ill equipped to clamp down on the excesses in the system.
(4) There was a systemic breakdown in accountability and business ethics.
(5) The collapse of private sector mortgage lending standards contributed to the problems.
(6) Unregulated over the counter derivatives trading was a significant factor in the Crash.
(7) Conflicts of interest in the rating agency business meant that it was all but impossible to determine the actual value of an investment, and contributed to the ultimate Crash. [Calculated Risk summary]
OK, that’s all history, why should it concern us today?
Because, the pure raw political power of the Financialists is on full display in the Congress of the United States of America. Those self-same Financialists whose speculation caused the Crash of 2008 and the subsequent recession are fighting like Spartans to return to their Good Old Days of unbridled speculation and unaccountable, opaque, transactions.
Think the banks aren’t still playing the trading game? Then see the OCC’s quarterly report for the end of 2011: (pdf)
“A total of 1,078 insured U.S. commercial banks reported derivatives activities at the end of the fourth quarter, a decrease of 10 banks from the prior quarter. Derivatives activity in the U.S. banking system continues to be dominated by a small group of large financial institutions. Five large commercial banks represent 96% of the total banking industry notional amounts and 86% of industry net current credit exposure.” (emphasis added)
There’s a chart of this activity from the OCC, wherein we see some counterparties expressing their nervousness about getting involved with more bank trading in derivatives, and some of the old “sell in December” common wisdom.
Thus we have five major banks dominating the derivatives markets. “Too Big To Fail” institutions that do not want to abide by the provisions of the Dodd-Frank Act which seeks to make derivative trading more transparent and accountable. AND Republican allies in the 112th Congress calling for the repeal of the Dodd-Frank Act requiring more transparency and accountability, and requiring that the banks have on hand a plan for Orderly Liquidation (Sounds so much nicer than bankruptcy doesn’t it?) in case they pull another major belly flop into the financial pool.
As of last August presumptive GOP presidential candidate Mitt Romney was all for repealing Dodd-Frank, except that he might agree with some of the credit derivative regulations, except that he wasn’t specific about which provisions he might support, except that he thinks the whole thing is “burdensome regulation.” [BostonGlobe] Let’s guess that the former CEO of Bain Capital isn’t receptive to much regulation of the financial sector?
The lack of specificity in Governor Romney’s comments notwithstanding, the Republicans in the House of Representatives are now pushing a bill to repeal the Orderly Liquidation portion of the Act as a “spending cut.”
“A U.S. House panel will consider a repeal of the power established by the Dodd-Frank Act to seize and wind-down systemically risky financial firms, a move that will draw opposition from House and Senate Democrats who have made a point of protecting the law enacted in 2010. […]
Republicans opposed the resolution authority during the 2009 and 2010 debate over the financial regulatory overhaul that would become Dodd-Frank. The law granted the authority to the Federal Deposit Insurance Corp., which could draw from the U.S. Treasury to resolve a firm and repay the taxpayer funds through an assessment on large financial firms.” [BusinessWeek]
In other words, the House GOP members are proposing that if the Financialists get themselves into yet another jackpot, the government cannot require that they have a “living will” such that their assets can be determined accurately and the U.S. taxpayer won’t be on the hook for the bill. We got stuck for the last one… now they want us to be liable for yet another?
But why ask for something “small” like repealing the Orderly Liquidation Authority when you can demand the repeal of the entire bill? Senator Jim DeMint (R-SC) authored and introduced S. 712 the “Financial Takeover Repeal Act,” with 28 co-sponsors, a list to which Senator Dean Heller (R-NV) added his name on May 18, 2011. [OC] We might label this bill “The Financialist Protection Act of 2012?”
We know about pain when the accounts with the stock broker take a major hit, how about pain at the pump? Senator Carl Levin (D-MI) summed up the current situation concerning speculation in the oil markets:
Before speculators flooded the markets, oil prices were determined by fundamental market forces of supply and demand. When supplies were tight and demand high, prices went up. In contrast, when supplies were ample and demand low, prices went down.
Nowadays, that relationship is largely absent. There is no shortage in the supply of oil globally, and the United States is producing more oil than it has in a decade.
Under normal economic conditions, rising production and lower demand should mean lower prices. Instead, prices are more volatile than ever.
One key reason is speculators are playing too large a role in the oil market. If we are to get a handle on oil prices, we have to curb excessive speculation.
Congress has taken the first steps. In July 2010, we told federal regulators to establish rules to prevent speculators from dominating markets and distorting prices. Last year, the regulators rolled out the new rules. They are not as tough as they should be, but the real problem is they are not yet fully in force.
That means this important new tool lies dormant. One big roadblock is that the financial industry has filed a lawsuit to stop it from taking effect. [TimesHerald](emphasis added)**
So, the Commodity Futures Trading Commission did its work, devised regulations to curb excessive speculation in the oil markets, and the financial industry promptly filed suit to prevent the regulations from going into effect. However, that’s not the only crimp in the issue. The CFTC has been the target of Republicans who are intent upon doing the bidding of the Financialists.
When Republicans charge that Democrats have been singularly unfeeling about “pain at the pump,” the question needs to be asked — Have you supported regulatory provisions which curb excessive speculation, or have you adopted the Financialist position that any effective regulation of derivative speculation is “burdensome?”
In May 2011 House Republicans circulated a proposal to cut the CFTC’s budget by 15%. [Bloomberg] On May 24, 2011 a Republican controlled House subcommittee voted in favor of that 15% cut, and suggested that implementing new CFTC rules be delayed until 2012. [Reuters] It’s not just the CFTC capacity to regulate its markets that in under fire from Congressional Republicans, they’d also like to cut the Security and Exchange Commission’s budget as well. As of March 1, 2011:
“Already, the SEC has delayed the creation of five key initiatives mandated by the Dodd-Frank, including a new office of women and minority inclusion and a whistle blower unit.
The SEC has also been forced to postpone depositions in some enforcement cases and has capped the number of expert witnesses it hires.”[CNN](emphasis added)
Now we wouldn’t want those pesky whistleblowers leaking information about financial and banking corporation mismanagement and illegal activities now would we?
Our Bottom Lines
What we have is a situation in which excessive speculation depresses investment in traditional capitalism, i.e. the investment in the expansion of manufacturing, in the credit needs of companies (large and small), and in the needs of American consumers. The excessive speculation threatens our financial institutions and even our freedom to fill the gas tank. Yet still the Republicans side with the Big Bankers in their efforts to repeal, logjam, underfund, and otherwise prevent the American people from seeing what the banks are doing, and from doing something about it when the bankers mismanage our financial resources for their personal gain.
We can mitigate the severity of the next financial downturn — IF we can regulate the volatility of our markets. But the Republicans prefer to side with the pro-volatility traders on the Wall Street Casino floor. We can alleviate some of the pain associated with financial sector crashes. But the Republicans are siding with the Big Banks which don’t want to disclose their risky assets in an Orderly Liquidation process. We can ease the pain at the gas station pump. But the Republicans don’t want any restrictions on purely speculative derivatives trading in the oil markets.
However most importantly — we need someone to send up the flares and call upon Americans to salvage what they can of our free market capitalist system and wrest it from the clutches of the Financialists.
*Review: Armistead’s classic definition of Financialism. To see other members of the Senate who have co-sponsored S. 712 click here. **Groups opposing CFTC regulations, includes Goldman-Sachs, Conoco-Phillips.