Why don’t we let Banks Fail?

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Bloomberg had a story, a couple of days ago, about BofA moving Merrill Lynch derivatives to its retail-banking subsidiary.

The story was quite long and hard to follow: there were lots of detours into explanations of what a derivative is, or explorations of what the BAC stock price was doing that day.

It seems that regulators care much more about Bank of America, the retail-banking subsidiary which holds depositors’ money, than they do about BAC, the holding company which owns Merrill Lynch. And the senior executives at Bank of America have a fiduciary duty to Bank of America — never mind the fact that their shareholdings are in BAC.

The Fed, in allowing and indeed encouraging this transfer to go ahead, is placing the health of BAC above the health of Bank of America. And that’s just wrong. Holding companies can come and go — it’s the retail-banking subsidiaries which we have to be concerned about. The Fed should not ever let risk get transferred gratuitously from one part of the BAC empire into the retail sub unless there’s a very good reason. And I see no such reason.

Comparing this to the Iceland banking crisis and three years after the collapse of their banking system and the country teetering on the brink, Iceland’s economy is recovering, proof that governments should let failing lenders go bust and protect taxpayers.

In fact, the lesson that could be learned from Iceland’s way of handling its crisis is that it is important to shield taxpayers and government finances from bearing the cost of a financial crisis to the extent possible.

Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. It imposed temporary controls on the movement of capital to give itself room to maneuver. No wonder it is doing today much better than virtually all of the countries which have let the banks push them around.

Rather than bailout the banks — Iceland could not have done so even if they wanted to — they guaranteed deposits (the way our FDIC does), and let the normal capitalistic process of failure run its course.

Unlike other nations, including the U.S. and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its biggest lenders in receivership. It chose not to protect creditors of the country’s banks, whose assets had ballooned to $209 billion, 11 times gross domestic product.

Countries with larger banking systems can follow Iceland’s example.

As the first country to experience the full force of the global economic crisis, Iceland is now held up as an example by some of how to overcome deep economic dislocation without undoing the social fabric.

While the conditions in Iceland are in many ways different from the conditions in the U.S., Iceland’s lesson applies to America, as well.

Specifically, a study of 124 banking crises by the International Monetary Fund found that propping banks which are only pretending to be solvent hurts the economy:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.

All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.

Bottom Line: I still strongly believe that our economy cannot and will not recover until the big banks are broken up.

If the politicians are too corrupt to break up the big banks (because the banks have literally bought them), why don’t we break them up ourselves?

Your feedback is as always greatly appreciated.

Thanks much for your consideration.

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On Tax Cuts for the Middle Class and the Wealthy

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It is a known fact today that extreme conservatives push for tax cuts (but just for the wealthy) and extreme liberals are against all tax cuts, believing that we need higher taxes to pay for government programs … and that taxes somehow won’t create any drag on the economy.

I believe both extremes are wrong.

In the real world, tax cuts for the middle class and poor stimulate the economy, but tax cuts for the wealthy hurt the economy.

Look at the facts: Taxes were cut in 2001, 2002, 2003, 2004 and 2006.

It would have been one thing if the Bush tax cuts had at least bought the country a higher rate of economic growth, even temporarily. They did not. Real G.D.P. growth peaked at just 3.6 percent in 2004 before fading rapidly. Even before the crisis hit, real G.D.P. was growing less than 2 percent a year…

According to a recent C.B.O report, they reduced revenue by at least $2.9 trillion below what it otherwise would have been between 2001 and 2011. Slower-than-expected growth reduced revenue by another $3.5 trillion….and spending was $5.6 trillion higher than the C.B.O. anticipated for a total fiscal turnaround of $12 trillion. That is how a $6 trillion projected surplus turned into a cumulative deficit of $6 trillion.

If you recall, it was George W. Bush’s father, GWH Bush, who, when campaigning against Reagan, called supply side economics’ claims that tax cuts pay for themselves Voodoo Economics. And Bush was proved right when deficits spiraled out of control and both Reagan and Bush were forced to raise taxes. In fact, the Bush tax cuts accrued disproportionately to the wealthy. The Tax Policy Center shows that 65 percent of the dollar value of the Bush tax cuts accrued to the top quintile, while 20 percent went to the top 0.1 percent of income earners.

If you want to talk about redistribution, there it is.

Bottom Line?

First, the rich spend a smaller proportion of their wealth than the less-affluent, and so when more and more wealth becomes concentrated in the hands of the wealth, there is less overall spending and less overall manufacturing to meet consumer needs.

Second, in both the Roaring 20s and 2000-2007 period, the middle class incurred a lot of debt to pay for the things they wanted, as their real wages were stagnating and they were getting a smaller and smaller piece of the pie. In other words, they had less and less wealth, and so they borrowed more and more to make up the difference. Between 1913 and 1928, the ratio of private credit to the total national economy nearly doubled. Total mortgage debt was almost three times higher in 1929 than in 1920. Eventually, in 1929, as in 2008, there were “no more poker chips to be loaned on credit,” in [former Fed chairman Mariner] Eccles’ words. And “when their credit ran out, the game stopped.”

And third, since the wealthy accumulated more, they wanted to invest more, so a lot of money poured into speculative investments, leading to huge bubbles, which eventually burst. Reich points out:

In the 1920s, richer Americans created stock and real estate bubbles that foreshadowed those of the late 1990s and 2000s. The Dow Jones Stock Index ballooned from 63.9 in mid-1921 to a peak of 381.2 eight years later, before it plunged. There was also frantic speculation in land. The Florida real estate boom lured thousands of investors into the Everglades, from where many never returned, at least financially. Tax cuts for the little guy gives them more “poker chips” to play with, boosting consumer spending and stimulating the economy.

Besides, small businesses are responsible for almost all job growth in a typical recovery. So if small businesses are hurting, we’re not going to see much job growth any time soon. On the other hand (despite oft-repeated mythology), tax cuts for the wealthiest tend to help the big businesses … which don’t create many jobs.

In fact, economics professor Steve Keen ran an economic computer model in 2009, and the model demonstrated that giving the stimulus to the debtors is a more potent way of reducing the impact of a credit crunch [than giving money to the big banks and other creditors]. And as discussed above, Reich notes that tax cuts for the wealthy just lead to speculative bubbles … which hurt, rather than help the economy.

Indeed, Keen has demonstrated that “a sustainable level of bank profits appears to be about 1% of GDP” … higher bank profits lead to a Ponzi economy and a depression. And too much concentration of wealth increases financial speculation, and therefore makes the financial sector (and the big banks) grow too big and too profitable.

Government policy has accelerated the growing inequality. It has encouraged American companies to move their facilities, resources and paychecks abroad. And some of the biggest companies in America have a negative tax rate … that is, not only do they pay no taxes, but they actually get tax refunds. Indeed, instead of making Wall Street pay its fair share, Congress covered up illegal tax breaks for the big banks.

For those who still claim that tax cuts for the rich help the economy, the proof is in the pudding. The rich have gotten richer than ever before, and yet we have Depression-level housing declines, unemployment and other economic problems.

No wonder Ronald Reagan’s budget director David Stockman called the Bush tax cuts the “worst financial mistake in history”, and said that extending them will not boost the economy.

What do you say?

Your feedback as always is greatly appreciated.

Thanks much for your consideration.

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7 Rock Solid Reasons Why Giant Banks Need to be broken up NOW

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After thorough analysis of the financial landscape, I strongly believe that giant banks need to be broken up NOW and before it is too late.

My rationale?

  1. Giant banks are the major reason why sovereign debt has become a major crisis today. In fact, the Bank for International Settlements (BIS) recently pointed out in a recent report that the giant bank rescue packages have transferred significant risks onto government balance sheets, which is reflected in the corresponding widening of sovereign credit default swaps. This was particularly apparent in the market for CDS referencing sovereigns involved either in large individual bank rescues or in broad-based support packages for the financial sector, including the United States. While such CDS were thinly traded prior to the announced rescue packages, spreads widened suddenly on increased demand for credit protection, while corresponding financial sector spreads tightened. In other words, by assuming huge portions of the risk from banks trading in toxic derivatives, and by spending trillions that they don’t have, central banks have put their countries at risk from default. Given that Greece, Ireland, Portugal, Spain, Italy and many other European countries – as well as the U.S. and Japan – are facing serious debt crises, we are no longer wealthy enough to keep bailing out the bloated banks….and since big banks hold 80% of the country’s derivatives risk, and 96% of the exposure to credit derivatives, it is clear that derivatives will never be reined in until the mega-banks are broken up.
  2. Giant banks sheer size are drawing the American and world economy down into a black hole. Again, size matters. If a bunch of small banks did what giant banks did, manipulation by numerous small players would tend to cancel each other out. But with a handful of giants doing it, it can manipulate the entire economy in ways which are not good for any world citizen. Hence, if we don’t break up the giant banks now, they’ll most probably be bailed out again and again, and will drag the world economy down with them. By failing to break them up, the government is guaranteeing that they will take crazily risky bets again and again, and will rack up more and more debt bailing them out in the future.
  3. Giant banks get too big a benefit from “information asymmetry” which disrupts the free market. Indeed, Nobel prize-winning economist Joseph Stiglitz recently noted that giants are using their size to manipulate the market. In some markets, they have indeed a significant fraction of trades. Why is that important? They trade both on their proprietary desk and on behalf of customers. When you do that and you have a significant fraction of all trades, you have a lot of information….and this raises serious potential of conflicts of interest, using that inside information for your proprietary desk. And that’s why the Volcker report came out and said that we need to restrict the kinds of activity that these large institutions have. If you’re going to trade on behalf of others, if you’re going to be a commercial bank, you can’t engage in certain kinds of risk-taking behavior. Giant banks have also allegedly used their Counterparty Risk Management Policy Group (CRMPG) to exchange secret information and formulate coordinated mutually beneficial actions, all with the government’s blessings.
  4. Giant banks use extensively high-frequency program trading which not only distorts the markets – making up more than 70% of stock trades – but also lets the program trading giants take a sneak peak at what the real (that is, human) traders are buying and selling, and then trade on the insider information. This is front running, which is illegal; but it is a lot bigger than garden variety front running, because the program traders are not only trading based on inside knowledge of what their own clients are doing, they are also trading based on knowledge of what all other traders are doing. Goldman itself recently admitted that its proprietary trading program can “manipulate the markets in unfair ways”.
  5. Giant banks are still barely lending today while small banks have been lending much more . In fact, giant banks which received taxpayer bailouts have been harming the economy by slashing lending, giving higher bonuses, and operating at much higher costs than banks which didn’t get bailed out. The only reason that smaller banks haven’t been able to expand and thrive is that the too-big-to-fails have decreased competition. It is a fact that the very size of the giants squashes competition, and prevents the small and medium size banks to start lending to Main Street again. Moreover, the banks’ enormous size means that the executives make orders of magnitude more in bonuses and salary than the executives of small banks. They are so big that their executives are living like kings. This is making inequality worse … and rampant inequality was another primary cause of the Great Depression and the current financial crisis.
  6. Since fraud was one of the main causes of the Great Depression and the current financial crisis, giant banks have become so big that they are buying off politicians to the extent that it has become official policy not to prosecute fraud. Indeed, everyone from Paul Krugman to Simon Johnson has said that the banks are so big and politically powerful that they have bought the politicians and captured the regulators. So their very size is allowing economy-killing corruption to flourish.
  7. Giant banks’ substantial portion of their profits is still essentially a redistribution from taxpayers to the banks, rather than the outcome of market transactions. Indeed, I believe ALL of the monetary and economic policy of the last 3 years has helped the wealthiest and penalized everyone else. A “jobless recovery” is basically a redistribution of wealth from the little guy to the big boys. The Bush tax cuts and failure to enforce corporate taxes also redistribute wealth to the top 1%. This is the biggest transfer of wealth in history, as the giant banks have handed their toxic debts from fraudulent activities to the countries and their people.

Now anyone who thinks that Congress will use the current financial regulation – Dodd-Frank – to break up banks in the middle of an even bigger crisis is dreaming.

But by the same token, I am afraid if the giant banks aren’t broken up now – when they are threatening to take down the world economy – they won’t be broken up next time they become insolvent either. In other words, there is no better time than today to break them up.

Failing to break them up will result in the sale of national assets and the looting of national treasuries in order to pay off debts to the giant banks. This, in turn, will destroy the national sovereignty of virtually every country out there.

What do you say?

Your feedback as always is greatly appreciated.

Thanks much for your consideration.

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What part did Hedge funds play in the crash of 2008?

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When Brooksley Born was interviewed on an episode of the PBS documentary series, Frontline, in October of 2009, it was the first time many viewers had ever heard of AIG’s involvement with credit default swaps. It was definitely the first time the majority of the American people had ever heard anyone quantify the depth of the abyss upon the edge of which Wall Street was teetering.

“We had no regulation,” testified the former chairman of the Commodity Futures Trading Commission (CFTC), who in 1998 had dared to cross swords with the Great and Powerful Greenspan. “No federal or state public official had any idea what was going on in those markets, so enormous leverage was permitted, enormous borrowing. There was also little or no capital being put up as collateral for the transactions. All the players in the marketplace were participants and counterparties to one another’s contracts. This market had gotten to be over $680 trillion in notional value as of June 2008 when it topped up. I think that was the peak. And that is an enormous market. That’s more than 10 times the gross national product of all the countries in the world.”

Not all derivatives are evil and destructive, but it is very crucial to understand the risks associated with these sophisticated products. This requires specialized high tech knowledge by professionals who have the necessary insight and expertise to know what tool to use and when it is appropriate.

The vast majority of hedge funds did not suffer significant damage due to the meltdown, although all of them certainly felt the shock waves. The ones that were most exposed and most leveraged are no longer with us.

Why has this gone on so long with no end in sight?

Because the Media has created and perpetuated the general perception that only people with money to burn invest in hedge funds. It is generally believed that the SEC has the opinion that if these rich people are so dumb as to give their money to Wild West fly-by-night money slingers, then they deserve to lose it. If it were the regular public that were losing their life savings, they say, it would be different story.

This is typical bureaucratic perception of financial reality.

The sad reality that everyone except the bureaucrats seems to have learned is that when all of the stupid rich people lose their money, the rest of the world economy suffers as well. This is why something real needs to be done about the more questionable hedge funds. I believe we need to have some regulation of the market, but it must be regulation that is well-thought out and anticipates unintended consequences.

I personally believe the SEC should require all hedge funds to operate in a true market-neutral mode, or not be allowed to call themselves hedge funds. It would be true capitalist caveat emptor (let the buyer beware) at its best.

As people put more and more money into hedge funds, another 1998 Long-term Capital Management debacle is just waiting around the corner to ignite another global financial crisis, requiring taxpayers to spend billions bailing out all of the firms that shouldn’t have been investing in them in the first place.

LTCM’s issue was ironically very similar to the issues that plagued Citibank most recently. The problem was not in what the fund traded nor in the strategies they followed, but in the size of their books and the fact that they had no limits on the overall volume of their arbitrage trades. They effectively became the market and couldn’t get out when things turned against them; and in the exposure of lenders to them, which no one was watching. It was therefore a question of unsupervised leverage and that is where the problem is in that sub-sector of the hedge fund industry. It is where the largest regulatory loophole is located.

This is what happened to Citibank and others more recently when the overall size of all of these deals went unchecked. This is where the regulators must find a way to measure the systemic risk of any particular fund. It is also why former SEC Chairman William Donaldson, CFA, has said this is the most distressing period since 1929.

“As hedge funds struggle to achieve returns,” he lamented. “I think there’s a tendency to skate on thinner and thinner ice, and it’s kind of an accident waiting to happen. ”

Bottom line on hedge funds

It is a fact that allocating a certain percentage of your investments to alternative investments does lower the volatility and risk of the traditional portfolio; but there is one very crucial difference between hedge funds and mutual funds.

Hedge funds are not infinitely scalable. Hedge fund managers cannot and do not accept unlimited amounts of capital. They all top out at some point and stop accepting additional investments as the capital available starts diluting their returns. Hedge fund managers rely instead on a small but steady inflow of investment capital that can be managed easier.

In the last few years, there has been an average of 2,000 new hedge funds start per year with about 1,500 closing within that time frame. This is not just due to losses. There are other factors, too; one of the main culprits is the inability to raise enough capital to sustain the operation. In general, allocators need at least two years of a successful track record before the may allocate money to a new fund. Many mangers cannot survive the costs alone and join with other funds. This also includes managers retiring after a long run. The bottom line is that the net number of funds is increasing, not decreasing, as a direct function of demand and the limited capacity of existing funds.

This increased demand for additional hedge funds to handle the amount of capital coming into the market has led, in the past, to unqualified and incompetent people setting themselves up as hedge fund managers. This is a very powerful incentive for literally thousands of people to set up new fake hedge funds every year – and most have no experience running money whatsoever. The Securities and Exchange Commission has done a less than stellar job of supervising and registering hedge fund managers. Commodities traders and managers whose funds deal with investing in any type of futures market must be registered with and are regulated by the CFTC.

What’s important is to close any regulatory loopholes that could cause a systemic problem due to the actions of one or more funds. The shenanigans of Bernie Madoff hurt not only his investors but also the hedge fund industry at large although he was NOT running a hedge fund operation. It did not help that the media failed to serve their primary mandate to inform and educate. Instead, they over-dramatized, sensationalized and misrepresented the issues; exacerbating the damage caused to the honest and innocent managers by Madoff’s actions.

The point is not to predict the future, but it is possible, for example, to identify trends. People need to understand the risks involved. There’s no such thing as a “riskless” investment.

Your feedback as always is greatly appreciated.

Thanks much for your consideration.

Sources

Born, Brooksley. Interview on Frontline. WGBH Educational Foundation. 20 October 2009. Retrieved from:

http://www.pbs.org/wgbh/pages/frontline/warning/interviews/born.html

Read more: http://www.pbs.org/wgbh/pages/frontline/warning/interviews/born.html#ixzz1PrXCELpb

Fulford, Mike (2010) Opinion on the Usage of Hedge Funds. Tools For Money website. Retrieved from:

http://toolsformoney.com/hedge_funds.htm

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Have we learned anything from the Financial Crisis of 2007?

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I would say nothing at all…. In fact, instead of changing their behavior to prevent another crisis, the Powers-that-be seem to be doubling down on the strategies that Caused the Financial Crisis in the First Place

Liberals blame deregulation and reckless Wall Street greed for the economic crisis. Conservatives blame bad government policy.

What are they doing? Well here again…. they are:

  1. Pushing banks to make home loans to people with weaker credit (sound familiar?)
  2. Deregulating and even promoting insane levels of derivatives (ring a bell?)
  3. Following policies which lead to rampant inequality (that didn’t work out so well last time)
  4. Letting white collar criminals know that they have free rein to do whatever they want, and they won’t be prosecuted (once again)
  5. Letting the giant banks get bigger and bigger (the government helped them get big in the first place)
  6. Bailing out the banks with hundreds of billions of dollars a year (which creates dangerous “moral hazard” – just like before the 2007 crisis – and once again destroys sovereign nations). Indeed, crony capitalism has gotten worse than ever (even though heroes have been fighting it for 100 years)
  7. Enacting policies which suck money out of the U.S. economy … and ship it abroad (as they’ve been doing for 50-plus years now)
  8. Enacting policies which discourage people from even trying to find work
  9. Giving the Federal Reserve more power than ever (while a neutral government agency says that the Fed is riddled with corruption, and economists say the Fed caused many of our problems in the first place, and has too much power for the good of the economy)
  10. Blowing insanely large speculative bubbles (when they burst in 2007, that caused the last crisis)

As to the big banks and financial institutions, looks like nothing has changed for them too as they are still engaged in the same risky behavior which got us into the 2007 crisis in the first place by:

  1. Trading even more risky derivatives than at the height of the financial crisis
  2. Taking insanely risky bets with the money that we deposit into our bank accounts. When some of their risky bets blow up, they will either look to the government – once again – for a bailout, or to our bank deposits
  3. Getting back into “synthetic” financial instruments – which are even more disconnected from real assets than regular derivatives
  4. Doing no-document mortgage loans

What could possibly go wrong?… Go figure

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