Archive for the ‘Economy’ Category

Obama’s Tax Plan and Small Business

November 17, 2010

Hello from Weston, CT, where we are proud to have elected or reelected a fine slate of Democratic candidates to Congress and major state offices:

There is a major misunderstanding of the proposal to end (not extend) the Bush tax cuts for top earners.  Media articles are not explaining what “$200,000 per individual or $250,000 per couple” means.  Republicans are exploiting the vagueness to scare small business owners.  The confusion is over the difference between AGI and taxable income.

We know that Michelle Bachmann is one of the most shameless liars to be elected to Congress.  However, some people listen to her.  Yesterday morning, Bachmann said to George Stephanopoulos that President Obama proposed to raise taxes on any small business with gross income of more than $250,000, including a carpet layer with two or three assistants. She says that would be a big job killer.

My understanding is that President Obama proposes to raise taxes on annual taxable income of more than $200,000 for an individual or $250,000 for a couple.  That’s not gross income.  For a business partnership or other unincorporated small business, salaries and other legitimate business expenses would be deducted before computing the taxable income.

There are very few small businesses with annual taxable income of more than $250,000, and the tax increase would be only 3% of the amount above $250,000.

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Why China Undervalues Its Currency

October 26, 2010

Yesterday, Brad DeLong described what he believes to be the primary Chinese rationale for its weak renminbi policy:

China has 900 million rural dwellers who are still living at a standard of living not that far above subsistence. The pressure to migrate from the countryside to the coastal cities is enormous. China needs to grow at more than 8% per year in order to avoid mass unemployment in the coastal cities. And mass unemployment in the coastal cities is likely to be followed by political collapse and turmoil on a gigantic scale.

Part of growing at 8% per year is to continue to rapidly expand exports to the North Atlantic core of the world economy. But in order to expand exports Chinese-produced goods must look like good values. And if demand for dollar-denominated assets falls and the value of the dollar falls, Chinese-produced goods will no longer look like good values.[i]

The U.S. policy problem is that the undervalued renminbi is leading to weak demand for U.S. goods and services in China.  The U.S. needs to reduce its trade deficit with China.

To reiterate, the five causes of high unemployment in the United States are:

  1. Inadequate aggregate demand.
  2. Migration of jobs to other countries, especially China.
  3. Increased productivity of employed workers.
  4. Inadequate credit for small businesses.
  5. Uncertainty about future taxes and regulations.

Aggregate Demand vs. Structural Unemployment

October 26, 2010

The U.S. unemployment rate has been stuck in the range of 9.5% to 10% since the beginning of the year, with many uncounted discouraged workers and many underemployed part-time workers.  Does this mean that we have structural unemployment?  Brad DeLong published a short paper today[i] arguing that our unemployment problem is currently due to inadequate aggregate demand, not structural unemployment.

DeLong explains that if we suffered from structural unemployment, then some sector such as construction would have high unemployment but another sector such as manufacturing would be booming and employers would be seeking qualified workers without success.  The actual situation, DeLong argues, is that almost all sectors of the economy have seen significant declines in employment, which is a symptom of inadequate aggregate demand.

Paul Krugman argued as usual yesterday that the $800 Billion American Recovery and Reinvestment Act of 2009 was wholly inadequate, providing mainly tax cuts, unemployment extensions and meager aid to state and local governments that was barely enough to offset declining state tax collections in the short term and not nearly enough to compensate for the precipitous decline in demand in the private sector in 2008-2009.[ii]

This does not mean that we are not in danger of falling into the trap of structural unemployment.  If the current high rate of unemployment persists for two or three more years, the long-term unemployed will lose their skills and become unemployable.  Then we will be in a worse economic mess than we are in now.  That is the danger of electing a Republican majority in Congress, which will block any further proposals by President Obama to stimulate the economy.

I reiterate the reasons for high unemployment in the U.S.[iii]

  1. Inadequate aggregate demand.
  2. Migration of jobs to other countries, especially China.
  3. Increased productivity of employed workers.
  4. Inadequate credit for small businesses.
  5. Uncertainty about future taxes and regulations.

Trade Friction with China

October 20, 2010

There have been several developments since I posted two weeks ago about jobs and industries being shipped overseas.  (“Causes of High Unemployment in the U.S.”)

The United States has ramped up the pressure on China to revalue its currency. Yesterday, Treasury Secretary Tim Geithner reiterated to a gathering in Palo Alto that the Chinese renminbi is significantly undervalued (despite a 3% revaluation over the past month or so).  He said that he is postponing the scheduled report on whether a major trading partner has been unfairly manipulating its currency value; he wants to coordinate his strategy with other aggrieved countries at the coming G-20 meeting in South Korea.

This is not first excuse Geithner has had for not publishing an accusation that China has been manipulating its currency.  Is he afraid of Chinese retaliation?  In the past, there has been speculation that the Chinese could retaliate by selling U.S. bonds, driving down the dollar.  Indeed, the dollar has declined about 7% against the euro and other currencies in the last two months, but not against the renminbi.  Is makes little sense to fear a potential Chinese action that would make the U.S. companies more competitive in international markets.  However, the Chinese have a more effective means of retaliation.

Last Friday, American trade officials announced that they would investigate whether China was violating international trade rules by subsidizing its clean energy industries. The inquiry includes whether China’s steady reductions in rare earth export quotas since 2005, along with steep export taxes on rare earths, constitute illegal (under WTO rules) efforts to force multinational companies to produce more of their high-technology goods in China.  The Chinese did not like that announcement, and they did not wait for the outcome of that investigation.

On Sunday evening, in an extremely rare move for a senior Chinese official, the country’s top energy policy maker, Zhang Guobao, called in reporters from international media organizations and objected to the American announcement.  Hours later, according to the New York Times[i], Chinese customs officials began singling out and delaying rare earth shipments to the West.  Today China denied that it had halted sales of rare earth shipments[ii], but the threat of a future cutoff has been duly noted.

Rare earth production is another example of the failure of American laissez faire economic policy in the face of competition from Asian managed economies.  Rare earths are important in the production of many high technology products, from advanced fighter avionics to high temperature superconductors to windmill blades.  China has about 30 percent of global rare earths deposits but accounts for about 97 percent of production. The U.S., Canada and Australia have rare earths but stopped mining them in the 1990s.

Just as consumer electronic industries moved to Asia, rare earth production moved to China over the last two decades because of lower costs.  Congress is considering legislation to provide loan guarantees for the re-establishment of rare earth mining and manufacturing in the United States, but new mines will probably take three to five years to reach full production.  Meanwhile, China will have an advantage in the production of high technology products, including clean energy products.

In his Palo Alto discussion, Secretary Geithner said he opposed the import tax on Chinese products advocated by Andy Grove (and that would be enabled by legislation that passed the House of Representatives recently) because that would provide subsidies to inefficient American companies as well as raising prices for consumers.  Geithner did not discuss Grove’s analysis of the need to rebuild a manufacturing infrastructure in order to compete in the development and production of new high technology products.

Our trade imbalance with China, largely due to the undervalued renminbi, remains a factor in the high unemployment in the United States.


Causes of High Unemployment in the U.S.

October 4, 2010

There has been an extensive and prolonged discussion in the media about the high unemployment in the United States since 2009.  Some commentators have focused on one cause, some on another.  This article discusses five causes of the current high unemployment, in the order of their importance:

  1. Inadequate aggregate demand.
  2. Migration of jobs to other countries, especially China.
  3. Increased productivity of employed workers.
  4. Inadequate credit for small businesses.
  5. Uncertainty about future taxes and regulations.

Aggregate Demand

Aggregate demand is the demand for goods and services from both the private sector and the public sector.  Demand in the private sector declined precipitously in the Fall and Winter of 2008-2009.

During the period from 2001 to 2007, average household income was stagnant, but there was a housing bubble, with housing prices in some areas doubling.  Homeowners felt wealthier and were able to refinance their homes or take home equity loans to maintain and improve their standard of living.  Banks created complex financial instruments based on mortgage loans, which were widely distributed in the belief that spreading the risk would somehow reduce the risk.  When the housing prices started falling, demand fell and the recession started, officially in the fourth quarter of 2007.

Falling housing prices led to financial crisis, epitomized by the bankruptcy of Lehman Brothers in September 2008.  Financial institutions no longer trusted each other, and the shadow banking system collapsed.  Households and businesses could not get loans.  The decline of housing prices and the tightening of loan standards meant that home equity loans became much more difficult to obtain.  Private-sector borrowing plunged from 28% of GDP in 2007 to minus 17% of GDP in 2009.  Layoffs began.   As unemployment increased, people did not have money to spend, and the economy spiraled downward.

The federal government acted to prevent a depression.  The Federal Reserve stepped in as the lender of last resort and provider of liquidity for many types of credit markets, increasing its assets from $900 billion to $2.3 trillion.

At the request of President George W. Bush and his treasury secretary, Hank Paulson, the Congress approved the $700 billion TARP program.  Treasury used the TARP funds to buy preferred shares in major banks, some of which were threatened with insolvency, as well as to rescue AIG, General Motors and Chrysler.   Most of the TARP funds has been or will be repaid to the Treasury.

At the request of President Barack Obama, the Congress passed the American Recovery and Reinvestment Act of 2009.  This act included $288 billion in tax cuts, primarily for the middle class.  The Congressional Budget Office originally scored the cost at $787 billion, but the tax cuts, unemployment insurance and Medicaid cost sharing with states have pushed the anticipated expenditures above $800 billion, of which about $533 billion has already been spent.  The Recovery Act has created or saved 2.5 to 3.6 million jobs.  However, 8 million jobs were lost in the recession that started in 2007, and the federal stimulus from the Recovery Act was not enough to reduce unemployment below its current level of 9.6%.

The national recession and weak recovery have produced both declines in state and local revenues and increased need for public programs as residents lose jobs, income, and health insurance. In the 2009 and 2010 fiscal years, the imbalance between available revenues and what was needed for services opened up budget gaps in most states. The Recovery Act gave states roughly $140 billion over a two-and-a-half year period to help fund ongoing programs, including K-12 education, higher education, and health care. However, the federal assistance will run out soon.  Most states have now addressed significant budget shortfalls in enacting their 2011 budgets and even more budget gaps are projected for fiscal year 2012. Total shortfalls for 2011 and 2012 (both those that have been addressed and that have yet to be closed) are likely to reach some $260 billion.  The shortfalls would be even higher in the absence of federal Recovery Act aid and the $24 billion state-aid bill to extend support for education and Medicaid for six more months.  Without additional federal aid and if states continue to cut spending as they have in the current fiscal year, the national economy is projected to lose up to 900,000 public- and private-sector jobs.[i]

To get the economy growing again, four out of five economists interviewed by Bloomberg Business Week agree the federal government should increase infrastructure spending.   There are thousands of unsafe bridges thousands of miles of railroad tracks that urgently need repair or replacement.  Our ports are vulnerable to terrorist attack.  Our national electricity distribution grid is a hodgepodge of outdated equipment, vulnerable to both natural and manmade disasters and urgently in need of redesign and upgrade.  The private sector is not going to take the initiative to do it, but the private sector will benefit greatly if the federal government funds and contracts with private companies to fix the national infrastructure.  Now is the time to do it.  It will provide jobs in the near term, but the benefit will continue.  Like the construction of the Interstate Highway System started by President Eisenhower, rebuilding the national infrastructure will lower costs for the private sector long after the federally contracted work has ended.

In addition, because states are required by their constitutions to balance their budgets even during recessions, the federal government should resume federal-state revenue sharing (first proposed and implemented by the President Nixon and ended by President Reagan).  This could save almost a million jobs.

Migration of Jobs to Other Countries

In 1992, erstwhile presidential candidate Ross Perot warned of a “giant sucking sound” of jobs going to Mexico if we ratified NAFTA.  We now know that the “giant sucking sound” did not come from Mexico, it came from Asia.

While the U.S. trade deficit in goods and services declined from $696 Billion in 2008 to $381 Billion in 2009[ii] because of the worldwide recession, it is rising again at an alarming rate.  For June 2010, the U.S. trade deficit was $49.9 billion, up from $42 billion in May, as exports dropped by the most in a year.[iii] Our trade deficit with China is rising and may reach $290 billon this year.  China accounts for more than half the non-petroleum trade deficit.  According to the Economic Policy Institute, the trade deficit with China has resulted in the loss of 2.4 million jobs over 2001-2008.[iv] An additional one-half million jobs could be lost to China this year.

Some economists say that China benefits from an undervalued currency, which it depresses by buying dollars and euros.  Indeed, China has foreign currency reserves of over $2.5 trillion.  The Chinese Renminbi is estimated to be undervalued by 35% to 40%.  This makes Chinese goods cheaper than they should be on the world market, and makes foreign goods, including American goods, more expensive in the Chinese market.  An exchange rate adjustment would make American goods less expensive in China, which would benefit American exporting companies, but would also benefit Chinese consumers, who have been complaining lately about inflation in China.  The Chinese government promised earlier this year to adjust the exchange rate, but there has been little change.  The Economic Policy Institute estimated that ending China’s currency manipulation could add as much 1.4 percent to economic growth in the U.S., based on calculations made by Nobel laureate Paul Krugman. That would lead to $500 billion in additional federal government revenue–or deficit reduction.  Krugman suggests we threaten a 25% tariff on all Chinese goods if China refuses to revalue its currency.[v] We also need to demand the end to illegal subsidies and other unfair trade practices by China and other countries.  While we should not repeat the mistake of broad Smoot-Hawley-style tariffs, a targeted approach may be in order, so long as it is done within WTO rules.

It is hard not to notice that so many goods we buy are made in Asia – clothing, toys, cell phones, television sets, personal and laptop computers, iPods, iPhones, iPads, and even the internet routers that link all these devices.  One company, Foxconn, employs 920,000 workers in China to manufacture the gadgets that are conceived and largely designed in the United States.  To a large extent, this situation is a result of Chinese mercantilist policies taking advantage of naïve American laissez-faire policies.  However, it also results from American investor pressure to lower costs for their own individual profit without regard to the consequences for American society as a whole.

Andy Grove, former chairman and CEO of Intel, published an excellent article in Bloomberg Business Week in July titled “How to Make an American Job”.  He writes cogently that America needs to reinvigorate its manufacturing base that has eroded so dramatically over the past thirty years.  It is only partially true that small businesses generate more jobs.  Our problem is that small businesses do not grow jobs as they used to, because successful small businesses are expanding overseas, building their manufacturing plants in Asia.  Many companies like Apple have generated ten times as many jobs in Asia as in the United States.  This happens not only because of low wages in Asia, but also because Asian countries like China have policies to encourage certain kinds of industries, especially manufacturing.  When American companies build their manufacturing plants overseas, engineering and management jobs go overseas as well.  The manufacturing experience grows in Asia, not the U.S., making it more likely that new technologies will be developed in Asia rather than the U.S.  Grove makes the point that laissez faire works better than communism, but the Asian model of government encouragement for manufacturing is working better than U.S. laissez faire policies in encouraging job growth.  U.S. government intervention is necessary to stop and reverse the hollowing out of American industry.

In the old days, the U.S. manufactured radios, television sets, hi-fi music systems, and personal computers.  However, production of all these products has shifted to Asia under the laissez faire economic policies of the past thirty years.  Some economists welcome the transfer of the production of these “commodity” products to “less developed” countries.  However, we have lost manufacturing skills that have made it difficult to compete in newer technologies.  Flat panel LCD display technology was invented in the United States, but the manufacturing base to support production was not here, so production of flat PC and TV displays scaled up in Asia.  Touch screen display technology was invented in the United States, but American companies went to Asia for mass production.  When Apple developed the iPhone, the production facilities for the main components were in Asia, so it was logical to give the production contract to Foxconn in China.  Semiconductor solar cells were invented in the United States, but now China is dominating the production of lower-cost solar power panels.  As the manufacturing skill shifts to Asia, engineering jobs go to Asia as well.

The United States cannot hope to maintain the American dream of full employment and a vibrant middle class without manufacturing.  Andy Grove says we need to stop the venture capitalist practice of encouraging every new technology startup to plan for production in China.  The government needs to offer financial incentives to keep new product manufacturing in the United States.  “The first task is to rebuild our industrial commons… Tax the product of off-shore labor.”  Use the resulting tax revenues to fund companies that will scale up their new product manufacturing operations in the United States.  We should encourage businesses to consider it their duty to support our industrial base as well as the American Society that made their business possible.

Increased Worker Productivity

Companies are investing in manufacturing equipment and information systems to increase the productivity of the workers they already employ, rather than investing in more employees.  Equipment and software sales increased 24.9 percent in 2Q10 after an increase of 20.4 percent in the first quarter.[vi] Many workers also report that, after deep cuts in their workforces, companies have not been hiring after their business started improving, leaving the existing employees with more work to do for the same salaries.

We don’t want to discourage greater efficiency, as long as it does not come from employee exploitation, because increased worker productivity should lead to improved living standards in future.

Inadequate credit for small businesses.

Small businesses are often said to be the engines of our economy.  In mid-2010, 45% of small businesses reported inadequate credit to support their needs.  The unavailability of credit constrains these small businesses from hiring new employees, and may jeopardize the jobs of existing employees.  The recently-enacted Small Business Jobs and Credit Act establishes a new $30 billion fund for community banks, which will leverage up to $300 billion in new private sector lending to small businesses.  The new legislation provides more than $12 billion in tax relief provisions and creates eight new small business tax incentives aimed to encourage expanded business planning for investments in operations and hiring additional workers.[vii]

On Business Uncertainty Constraining Hiring

Verizon CEO Ivan Seidenberg has said that uncertainty about future taxes and regulation is constraining hiring.[viii] While we have heard this assertion repeated by Republican leaders, we find little compelling evidence to support it.  Uncertainty about the economic expansion is a credible constraint on hiring.  Companies may not feel the need to hire if their markets are only expanding 1% or 2% annually.  However, business leaders are accustomed to making decisions in the face of uncertainty.  Launching satellites or drilling for oil in a new area involves uncertainty, but businesses make those decisions.  Anytime a new product is introduced, there is uncertainty about the size of the market and whether customers will buy it.  Remember New Coke?  How about the Edsel?  Who knew Google would be so successful selling online advertisements?  On April Fools Day 2009, what would the reaction have been if you had said that Susan Boyle’s recording sales were about to make a dramatic change?  When Apple was looking for a wireless carrier partner, there was uncertainty as to the market for the new iPhone.  It might have been a money loser for the carrier who partnered with Apple.  Mr. Seidenberg did not know that AT&T would gain market share and profit from the deal.  (AT&T had to hire many people to sell iPhones and expand its network to keep up with the demand for its services.)  Business leaders who don’t like to make decisions under uncertainty will always have difficulty competing.


[i] http://www.cbpp.org/cms/?fa=view&id=1214

[ii] http://www.census.gov/foreign-trade/statistics/highlights/annual.html

[iii] http://www.bloomberg.com/news/2010-08-11/u-s-trade-deficit-unexpectedly-widens-to-49-9-billion-as-exports-decline.html

[iv] http://www.epi.org/publications/entry/bp260/

[v] http://www.nytimes.com/2010/03/15/opinion/15krugman.html?_r=2

[vi] http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.html

[vii] http://www.suite101.com/content/nuts-and-bolts-of-the-small-business-jobs-and-credit-act-of-2010-a289622

[viii] http://www.washingtonpost.com/wp-dyn/content/article/2010/06/22/AR2010062205279.html (Mr. Seidenberg was more reticent to talk about Verizon charging its wireless customers for services they had not contracted for and were not using.)

Causes of Current Federal Deficit

October 3, 2010

An article in the June 24 issue of the Westport Minuteman described Dan Debicella as saying “Jim Himes voting record has led to the $1.4 trillion [federal budget] deficit.”  Debicella also said the $800 billion stimulus package (American Recovery and Reinvestment Act) enacted in February 2009 was both unnecessary and ineffective, and Congressman Himes committed a grave error in voting for it.  Mr. Debicella proposes to repeal the act.  In blaming President Obama and Mr. Himes for the current deficit, Mr. Debicella apparently has a poor memory and a poor understanding of economics.

The article did not mention that President George W. Bush handed Barack Obama a federal budget deficit of $1.2 trillion in January 2009 as well as an economy declining more rapidly that at any time since the 1930s.  Economic stimulus was needed to stop the downward spiral caused by the impending collapse of the financial sector as well as the housing sector, which had not been adequately regulated during Republican control of all three branches of government, as well as the Federal Reserve.

The Great Recession started in December 2007, more than a year before Barack Obama and Jim Himes took office.  This recession was caused by failed Republican policies of deregulation and unfunded war.  (Remember how Bush saved us from Iraq’s weapons of mass destruction that did not exist?)  Congress funded TARP at the request of President Bush.  Hank Paulson, Treasury Secretary until 2009, has said that if Bush had not reversed course and funded the bank bailout and initiated the bailout of the auto industry, we would have had 20% unemployment.  President Obama and Jim Himes have been working tirelessly to fix the mess left by the Republicans.

It should be noted that it was a Democratic Administration that produced the only balanced federal budgets in a generation.  President Clinton inherited a large (for those days) budget deficit from President George H.W. Bush.  Proper Democratic Administration fiscal policy and Congressional Paygo rules produced budget surpluses during the last three years of Clinton’s second term, and there was serious talk of paying down the national debt to very low levels in preparation for the retirement of the baby boomer generation.  Although the recession of 2002-2003 would probably have led to a temporary budget deficit, we should have had a federal budget surplus again by 2005 if President George W. Bush had followed equally sound fiscal policies.  However, he was influenced by V.P. Dick Cheney, who said deficits did not matter.

Republican deregulatory policies wrecked the U.S. economy.  Alan Greenspan, appointed to the chairmanship of the Federal Reserve by President Reagan, followed the Republican deregulatory philosophy and urged people to take adjustable rate mortgages instead of fixed-rate mortgages with payments they could be sure they could afford.  When no down payment mortgages and liar loans were offered by mortgage brokers, Greenspan looked the other way and the Bush Administration asserted federal jurisdiction to prevent five state attorneys general from investigating the use of fraudulent and deceptive sales tactics by mortgage brokers.  This fueled the pipeline to Wall Street firms that created collateralized debt obligations and sold the CDOs to foreign banks, pension funds, etc., obscuring the risk involved in the inevitable downturn of the housing market.

In a June 2008 speech, President and CEO of the NY Federal Reserve Bank Timothy Geithner — who in 2009 became Secretary of the United States Treasury — placed significant blame for the freezing of credit markets on a “run” on the entities in the shadow banking system. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls as banks. Further, these entities were vulnerable because of maturity mismatch, meaning that they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at depressed prices.

Paul Krugman, winner of the 1999 Nobel Prize in Economics, described the run on the shadow banking system as the “core of what happened” to cause the crisis.  A sudden drop in liquidity led to a sharp downward spiral in aggregate demand, and we started seeing 700,000 jobs lost every month.  It is well documented that the $800 billion stimulus package has created or saved between 2 million to 3 million jobs.  However, Prof. Krugman said in February 2009 that an $800 billion stimulus was not enough, and recent developments indicate that he may have been right.

In testimony to a Congressional committee investigating the causes of the financial crisis, Alan Greenspan admitted that there had been a flaw in his philosophy of financial market deregulation.  Essentially, the flaw was that financial markets do not regulate themselves as efficiently as he had assumed.

One of the lessons that we should have learned from the Great Depression is that early attempts to balance the budget will not work.  In general, premature attempts to balance a national budget will lead to an economic downturn.  The resulting downturn will reduce tax revenues, making it harder to balance the budget.  This is what happened in 1937, when political pressure forced President Roosevelt to reduce federal spending.  The net federal deficit was reduced almost 90% from 1936 to 1937.  The result was another severe recession.  In 1938, the deficit rebounded to 60% of its 1936 peak, not because of increased spending but because of reduced tax revenues.  Other countries have had similar experiences.

Joseph Stiglitz, another Nobel Prize-winning economist, has said that one of the many ironies that have marked the crisis is that Greenspan’s and Bush’s attempt to reduce the role of government has resulted in a large temporary increase in the government’s role in the economy.  Barack Obama and Jim Himes, like the main stream of the Democratic Party, are in favor of a well-regulated market economy.  As the economy recovers, the government will sell its stakes in CitiGroup, AIG, and General Motors.  Indeed, this has already started.  The Government will get most of its money back.

What we will not get back is the trillions of dollars of lost output from the idle capacity and millions of unemployed people.  That lost output is the result of the failed Republican policies, and a return to those laissez faire policies of the past 25 years would be a tragic mistake leading to even more lost output and misery for people who are out of work due to no fault of their own.  This tragic situation can only be remedied by increasing aggregate demand, and government will have to do its part.

New Financial Services Industry Regulation

January 24, 2009

Today the New York Times reported that the Obama Administration will soon adopt this blog’s recommendations concerning regulation of the financial services industry, including stricter federal rules for hedge funds, credit rating agencies and mortgage brokers, and greater oversight of the complex financial instruments, such as CDOs, that contributed to the economic crisis.

Soon Paul Volker and Timothy Geithner will propose new federal standards for mortgage brokers who issued many unsuitable loans and are largely regulated by state officials. They are considering proposals to have the S.E.C. become more involved in supervising the underwriting standards of securities that are backed by mortgages.

“The administration is also preparing to require that derivatives like credit default swaps, a type of insurance against loan defaults that were at the center of the financial meltdown last year, be traded through a central clearinghouse and possibly on one or more exchanges. That would make it significantly easier for regulators to supervise their use.”[i]


[i] http://www.nytimes.com/2009/01/25/us/politics/25regulate.html?hp

Financial Industry Regulatory Framework Pending

December 4, 2008

The Congressional Financial Industry Rescue Panel led by Harvard Law Professor Elizabeth Warren is supposed to monitor the disbursement of the $700 billion in bailout money, but it is also required by law to provide Congress with recommendations for reforms to the financial regulatory structure, a report that she said it would deliver by Jan. 20.[i]  What kind of regulatory structure should be considered?

To prevent a recurrence of the problems that led to this current financial crisis, the United States and indeed the entire world need a new rigorously enforced regulatory structure for the financial services industry.  In the United States, legislation is needed to establish a streamlined framework for regulating the equity, debt, commodity and derivatives markets.  The functions of the SEC and CFTC, as well as functions undertaken by the Fed and the Treasury on an ad hoc basis, should be transferred to this new regulatory agency.[ii]

The federal government needs to regulate all aspects of the financial services industry.  As Barack Obama said in his speech on March 27, 2008, “We need to regulate financial institutions for what they do, not what they are.”[iii] The basic principles should be based on asking what role the financial institution plays in the economy.  If it is accepting and keeping retail and commercial deposits, with FDIC insurance, it should be regulated as a commercial bank.  If it invests the shareholder capital in risky assets, using leverage to increase its returns, it should be regulated as an investment bank.  Some 21st Century version of Glass-Steagall is necessary to protect taxpayers from the need to bail out investment banks.

With Elizabeth Warren as chairman of the Financial Industry Rescue Panel, we can expect a strong consumer protection element in the recommendations.  She has recently proposed that mortgage products should be examined and tested for safety.    She and her daughter Amelia Warren Tyagi wrote “Of all the borrowers who were sold subprime mortgages in the past five years, nearly 60 percent would have qualified for prime mortgages if brokers had offered them; the subprime mortgages carried so many rate escalators, prepayment penalties, and other traps that even would-be prime borrowers defaulted.”[iv]  When actual costs and unfavorable terms are regularly concealed, the regulatory authority should order those products removed from the market.  Warren and Tyagi have proposed a Financial Product Safety Commission, which would require that companies reveal the true cost of credit.  This is a good idea, and should be included in the recommendations, but it is a small part of the reforms needed to protect the 21st Century economy from another financial meltdown.

Leverage needs to be controlled for all financial institutions, whether they are called banks or insurance companies or hedge funds or commodity futures trading companies.  No company should be allowed to operate with so much leverage that its failure could threaten the entire global financial system, a situation in which we have found ourselves during the past two years.  To be more specific, leverage of 30:1 is outrageously too high.  Fines are not a sufficient deterrent to the greed of some people who will use high leverage whenever they think they have a chance to make a large fortune risking other people’s money.  Legislation needs to specify significant prison time for people who violate the rules of the new financial system. 

Now that we have mentioned hedge funds, the question is whether they have any redeeming social value.  Banks keep depositors money safe and put money to work by lending to households and businesses based on the lender’s assessment of their ability to pay the loans back.  Insurance companies spread risk among large groups of customers, sparing the focus of hardship on the unlucky few.  Financial advisers help people and businesses save and invest wisely.  Venture capitalists raise funds for entrepreneurs who create innovative products and services.  Hedge funds should not be allowed to exist just to gamble on giant returns by using greater leverage than is allowed of regulated financial institutions.  As a minimum, hedge funds should be regulated with regard to leverage and the transparency of their operations.  If hedge funds cannot find a contributing role in the real economy, they should be shut down.

The new financial order must ensure the independence of the financial rating companies.  We need to separate the funding of financial rating companies (like Moodys, Standard & Poors, and Fitch) from the financial engineers who came to them for ratings.  We have suffered from a system under which bond issuers paid the ratings companies to rate their bonds, and the ratings companies sold consulting services to tell the issuers how to tweak the composition of their Collateralized Debt Obligations to get AAA ratings. The federal government needs to police conflicts of interest like that.

Transparency is a key issue.  New Deal legislation sought to increase transparency in the interstate offering and sale of securities.  The Securities Act of 1933 requires every U.S. public company to register new securities (with the SEC after 1934) and to offer (interstate) securities only through a truthful prospectus giving basic financial information as well as stating the risk involved in investing in the offered securities.  Corporations were also required to issue audited annual reports on the status of the business.  The Securities Exchange Act of 1934 focused on the sale of securities in secondary markets, creating the Securities and Exchange Commission (SEC) to monitor and enforce corporate reporting, ensure conformance with regulations, as well as to detect and punish accounting fraud, false information distribution, insider trading or other violations of the securities law.[v]  Unfortunately, despite additional legislation (e.g., the Investment Company Act of 1940, the Investment Advisors Act of 1940, and the Sarbanes-Oxley of 2002), federal laws have not kept up with the pace of financial chicanery (described in the industry as innovation).

There needs to be more transparency of all kinds of financial instruments, including the kind of mortgage-backed securities, collateralized debt obligations and credit default swaps that have created the multi-trillion dollar financial meltdown we have experienced over the past eighteen months.  For example, standardized credit default swaps should be traded through a CDS clearinghouse (something that Tim Geithner has been encouraging in recent months). Legislation is needed to establish a streamlined framework for regulating the equity, debt, commodity and derivatives markets.  The functions of the SEC and CFTC, as well as functions undertaken by the Fed and the Treasury on an ad hoc basis, should be transferred to this new regulatory agency.[vi]

Size is also an issue.  No financial institution should be allowed to grow into a company that it is too big to fail.  Sandy Weill was right when he predicted the repeal of the Glass-Steagall Act after he created Citigroup, but he was also right in what he implied, which was that he had created an institution that had an inherent advantage over its rivals because it was too big to fail.  Citigroup must be broken up.  If the Citigroup management does not spin off parts of its business voluntarily, then antitrust litigation should be used to break up the company.  Furthermore, we need to reverse the trend during the Paulson era of turning to the biggest banks to absorb other big banks that get into trouble.  We must ensure that there are no more Citigroups in the future.

We hope that that the Warren Panel will lay out a framework by January 20 and then work with the new Economic Recovery Advisory Board to be chaired by Paul Volker to address in more detail the proposed financial system regulatory framework.

 


 

[i] http://www.nytimes.com/2008/12/02/business/02tarp.html?_r=1

[ii] https://westonpolicy.wordpress.com

[iii]http://www.prospect.org/cs/articles?article=seven_deadly_sins_of_deregulation_and_three_necessary_reforms

[iv] http://www.law.harvard.edu/news/2008/10/23_warren.html

[v] http://en.wikipedia.org/wiki/U.S._Securities_and_Exchange_Commission

[vi] https://westonpolicy.wordpress.com

Rescuing Wall Street — What about Moral Hazard?

November 26, 2008

Invoking moral hazard instead of rigorously regulating the financial industry has resulted in the worst financial crisis since the early 1930s.  To prevent a recurrence of the problems that led to this financial crisis, the United States and indeed the entire world need a new vigorously enforced regulatory structure for the financial services industry.

Citigroup Bailout

On Monday, the Bush Administration announced the terms of the Citigroup bailout.  Over the weekend, Citigroup identified a pool of U.S. residential and commercial mortgage loans, leveraged business loans and other related assets with a nominal value of $308 billion; the U.S. government agreed to provide insurance.  For that asset pool, Citigroup agreed to be responsible for the first $29 billion in losses, and 10% of the remaining losses, with the U.S. government picking up the rest.  The government risk was assigned among agencies as follows:  The Treasury will take the first $5 billion in government losses, and the Federal Deposit Insurance Corp. will absorb the next $10 billion in losses. If the asset pool losses exceed those triggers, the Federal Reserve will grant a loan for the remaining losses.  In exchange for that insurance, Citigroup sold $27 billion in preferred stock to the U.S. Treasury for $20 billion.  The preferred stock will have a dividend rate of 8%.[i] 

Conditions of the rescue included an agreement that Citigroup will not pay quarterly dividends of more than 1 cent a common share for three years unless the company obtains consent from the three federal agencies, as well as restrictions on executive compensation, including bonuses. Commentators said the deal raised the issue of moral hazard in dealing with large financial institutions.[ii]

Definition of Moral Hazard

According to Wikipedia, “Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions…  [In finance], a moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Taxpayers, depositors, and other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.”[iii]

Role of the Concept of Moral Hazard in Paulson Actions

Treasury Secretary Hank Paulson has worried publicly about moral hazard while dealing with the current financial crisis, which began in the Spring of 2007 when more than the expected percentage of subprime mortgages started defaulting.  Two Bear Stearns hedge funds, which used high leverage to buy subprime mortgage-backed securities and also bought credit default swaps to reduce risk, collapsed and were liquidated in July 2007.  For the rest of 2007, the damage seemed to be contained, but during the week of March 10, 2008, rumors and short sellers brought down Bear Stearns.  On March 16, 2008, under the leadership of Hank Paulson and Ben Bernanke (chairman of the Federal Reserve), the government encouraged J.P. Morgan Chase (Jamie Dimon, CEO) to acquire Bear Stearns at a low stock price – originally $2 but a week later raised to $10 per share.  To facilitate the deal, the Federal Reserve Bank of New York gave a loan of $29 billion, to be repaid from the sale of Bear Stearns assets valued at $30 billion in a mark-to-market exercise on March 14, 2008.[iv]   Mr. Paulson argued that the large decline in Bear Stearns stock price in the week before the acquisition (and a $133 per share 52-week high) negated the moral hazard concern.

To try to avert a recession, Congress authorized and the U.S. Treasury sent economic stimulus checks to almost everyone in the country.  The Bush Administration hoped that an economic downturn had been averted.  However, oil and gasoline prices went up during the summer of 2008, housing prices continued to decline, and mortgage delinquencies continued to rise.  A few people started to worry about derivatives such as credit default swaps.  Home foreclosures started to set records.

Fannie Mae and Freddie Mac

As concern mounted about the solvency of Fannie Mae and Freddie Mac, Treasury Secretary Paulson requested from Congress the authority to bail them out if necessary.  The Housing and Economic Recovery Act of 2008-passed by the United States Congress on July 24, 2008 and signed into law by President George W. Bush on July 30, 2008-expanded regulatory authority over Fannie Mae and Freddie Mac by the newly established Federal Housing Finance Agency (FHFA), and gave the U.S. Treasury the authority to advance funds for the purpose of stabilizing Fannie Mae, or Freddie Mac, limited only by federal debt limits, which were increased.

On September 7, 2008, James Lockhart, director of the FHFA, announced that Fannie Mae and Freddie Mac were being placed into conservatorship of the FHFA.  He cited their combined losses of $14.9 billion and their difficulty in raising sufficient fresh capital to continue to perform their mission as mortgage defaults continued to climb.  Treasury Secretary Paulson and Federal Reserve Chairman Bernanke sat next to Lockhart as he told the CEOs of Fannie and Freddie that they were losing their jobs as part of the takeover.  The takeover was described as one of the most sweeping government interventions in private financial markets in decades, but Congress had created these Government-Sponsored Enterprises (GSE) to provide liquidity in the home mortgage market, and most investors had assumed all along that Fannie Mae and Freddie Mac bonds would be backed by the U.S. Government if any difficulty arose.  The Treasury committed to invest as much as $200 billion in preferred stock and extend credit through 2009 to keep the GSEs solvent and operating.  To assert moral peril, the common stockholders lost their entire investment, and preferred stock dividends were suspended.

In suspending Fanny and Freddie’s preferred dividends, the Treasury and the Fed underestimated the impact on ordinary Main Street banks, which were only allowed to own preferred stock.  According to the Financial Times, “Nearly a third of US banks hold preferred stock issued by the two mortgage financiers that were taken into conservatorship…, according to an industry survey conducted by the ABA. The average bank exposure to such securities relative to core equity capital was 11 per cent.”[v]  The preferred dividend suspension wiped out $36 billion in capital that U.S. banks had to write down, at the same time the Treasury and the Fed were trying to improve the capital position of banks, both large and small.  Thus another mess was created in the name of minimizing moral hazard.

Lehman Brothers Bankruptcy

Allowing Lehman Brothers go bankrupt on September 15, 2008, in an attempt to minimize future moral hazard, turned out to be a huge mistake. In addition to many thousands of creditors holding its bonds, Lehman had made derivatives deals with 8000 firms, and other firms held credit default swaps with notional value of hundreds of billions that were triggered by the Lehman bankruptcy. Lehman was reported to be involved in as much as $1 trillion in outstanding derivative transactions.  The entangling counterparty risk was enormous, affecting financial institutions as well as individuals all over the world.  Scores of hedge funds that had hundreds of millions in cash and other securities parked with Lehman’s prime brokerage operation in London had their accounts frozen.[vi] Law suits abounded, asking for the return of frozen collateral.  Wind farm operators were left to scramble for alternate sources of funding, because Lehman Brothers had had a big green energy program.

Before the election, and long before Barack Obama started assembling his economic policy team, Ezra Klein reported that Tim Geithner had argued in favor of rescuing Lehman Brothers, it could not be allowed to file for bankruptcy, because the entangling counterparty risk was too great for the markets to handle.[vii]  Hank Paulson said Congress wanted to send a signal that bad risk management would not be rewarded.  Lehman fell.  The result was a catastrophe.  Despite the government rescue of AIG the following day, financial institutions lost all trust to lend to each other, and the credit crisis reached disaster proportions.  Swap sellers sold equities to raise cash to pay swap buyers, driving down global stock markets.  In the two months following the Lehman Brothers bankruptcy, the U.S. stock market alone declined approximately $5 trillion in addition to the approximately $3 trillion decline from its peak to the last trading day before the Lehman bankruptcy.  That is quite a price to pay to minimize moral hazard.

How did we get into this mess?

The primary cause of the current financial crisis was the deregulation of the financial services industry, not moral hazard.  The precursor was the Savings and Loan Crisis.  S&Ls had previously been restricted to investing depositor funds in home loans and community development projects.  During the Reagan Administration, S&L deposit insurance was raised from $20,000 to $100,000 per account, and S&Ls were allowed to invest in any real estate project they wanted – shopping malls, out-of-state hotels, even casinos. Risk-taking S&L executives lost money on poor investments.  The Federal Savings and Loan Insurance Corporation was overwhelmed by the losses, and the federal government was forced to close many S&Ls, refund depositors’ money and take over foreclosed properties. 

Remembering the lessons learned from the S&L crisis, Congress passed the Home Ownershi and Equity Protection Act (HOEPA) in 1994, giving the Federal Reserve the power and duty to regulate the mortgage lending industry, to require adequate disclosure and prevent predatory lending.  However, Federal Reserve Chairman Alan Greenspan, a lifelong Republican, was reluctant to regulate mortgage lending.  Dr. Greenspan publicly encouraged people to make use of adjustable rate mortgages, which he said would lower the cost of home ownership.

When, in July 1998, the Commodity Futures Trading Commission proposed to regulate OTC financial derivatives such as swaps, SEC Chairman Arthur Levitt objected.  Less than two months later, we almost had a world-wide financial crisis when highly-leveraged LTCM collapsed but was saved by several commercial and investment banks at the instigation of the Treasury and the Federal Reserve.  

Unfortunately, our government leaders learned nothing from the LTCM near-disaster in 1998.  Alan Greenspan (with support from Treasury Secretary Robert Rubin) persuaded Congress to pass legislation removing from the CFTC the power to regulate financial derivatives.  The OTC derivatives market remained unregulated, providing a means for banks and other financial institutions to skirt capital requirements and increase their leverage.

In 1999, a Republican Congress repealed the Glass-Steagall Act, a cornerstone of New Deal regulation.  The Glass-Steagall Act of 1933 created the Federal Deposit Insurance Corporation (FDIC) and separated investment banks from commercial banks.  Commercial banks were part of the banking system. They created credit. They were regulated, supervised, usually enjoyed FDIC insurance, and had access to advances from the Fed in emergencies. Investment banks were allowed to take more risks in their investments, but any losses on those investments would have to be borne by their shareholders, not the government.[viii]

However, during the Reagan Administration in the 1980s, regulators who didn’t believe in regulation either allowed explicit waivers of some aspects of Glass-Steagall or looked the other way as commercial banks and investment banks became more alike. In 1998, Travelers CEO Sandy Weill created the world’s largest financial supermarket Citigroup, with $700 billion in assets, via a $140 billion merger of the consumer and commercial banking giant Citicorp with the financial services conglomerate Travelers Group, whose businesses covered credit card services, consumer finance, retail brokerage, bond trading, investment banking and insurance.[ix]  The deal would enable Travelers to market mutual funds and insurance to Citicorp’s retail customers while giving the banking divisions access to an expanded client base of investors and insurance buyers.  This merger was a gross violation of the Glass-Steagall Act.  The basic premise of Glass Steagall had been to prohibit retail banks from selling common stocks to unsophisticated depositors, and to segregate insured banks from the risk-taking culture of investment banks.   This merger was not the first violation of the Glass Steagall Act, just the most flagrant.  Weill predicted at the time of the merger that legislation would obviate the need to divest prohibited assets.  Under the leadership of Senator Phil Gramm (R, Texas), and supported by Treasury Secretary Larry Summers, Glass-Steagall was officially repealed in November 1999 by Gramm-Leach-Bliley Act.[x]

In 2000, the Federal Reserve established an advisory committee chaired by Walter Shipley, former CEO of Chase Manhattan Bank.  The Shipley panel recommended specific changes in regulatory oversight to improve risk management and to require better disclosures for all financial institutions.  However, Fed Chairman Greenspan chose to ignore the recommendations of the Shipley committee, as he had ignored HOEPA.  Last month, Alan Greenspan admitted to a hostile Congressional Oversight Committee that his deregulatory philosophy had a flaw.  Thanks a lot, Mr. Greenspan.  Ten years too late!

Deregulation ideology continued to prevail in this decade. In 2003, the Federal Government preempted authority from the states when several state Attorneys General tried to investigate and rein in deceptive and fraudulent peddling of subprime mortgages.  In 2004, the SEC held a basement hearing with only representatives of five major investment banks, including Goldman Sachs – led by Hank Paulson, now Treasury Secretary – in attendance, and agreed to relax capital requirements on those banks, and allow them to operate at higher leverage.  Meanwhile, the unregulated credit default swap market grew from $900 billion in 2000 to $62 trillion in 2007, or four times U.S. GDP, threatening the entire global capitalist system.[xi]

Treasury Secretary Hank Paulson has been consistently behind the curve in dealing with this financial crisis.  Nationalizing Fannie Mae and Freddie Mac in the waning days of summer (September 7, 2008) was the right thing to do.  However, allowing Lehman Brothers go bankrupt on September 15, 2008 turned out to be a huge mistake. In addition to many thousands of creditors holding its bonds, Lehman had made derivatives deals with 8000 firms, and other firms held credit default swaps with notional value of hundreds of billions that were triggered by the Lehman bankruptcy.  The entangling counterparty risk was enormous, affecting financial institutions as well as individuals all over the world.  Financial institution lost all trust to lend to each other, and the credit crisis reached disaster proportions.  Swap sellers sold equities to raise cash to pay swap buyers, driving down global stock markets.  In the two months following the Lehman Brothers bankruptcy, the U.S. stock market alone declined approximately $5 trillion in addition to the approximately $3 trillion decline from its peak to the last trading day before the Lehman bankruptcy.  Millions of people will lose their jobs as the recession deepens.  Millions of hard-working people with limited financial acumen have seen their savings destroyed and their retirement dreams deferred.

Where does financial services policy go from here? 

The federal government needs to regulate all aspects of the financial services industry.  As Barack Obama said in his speech on March 27, 2008, “We need to regulate financial institutions for what they do, not what they are.”[xii] The basic principles should be based on asking what role the financial institution plays in the economy.  If it is accepting and keeping retail and commercial deposits, with FDIC insurance, it should be regulated as a commercial bank.  If it invests the shareholder capital in risky assets, using leverage to increase its returns, it should be regulated as an investment bank.  Some 21st Century version of Glass-Steagall is necessary to protect taxpayers from the need to bail out investment banks.

Leverage needs to be controlled for all financial institutions, whether they are called banks or insurance companies or hedge funds or commodity futures trading companies.  No company should be allowed to operate with so much leverage that its failure could threaten the entire global financial system, a situation in which we have found ourselves during the past two years.  To be more specific, leverage of 30:1 is outrageously too high.  Fines are not a sufficient deterrent to the greed of some people who will use high leverage whenever they think they have a chance to make a large fortune risking other people’s money.  Legislation needs to specify significant prison time for people who violate the rules of the new financial system. 

Now that we have mentioned hedge funds, the question is whether they have any redeeming social value.  Banks keep depositors money safe and put money to work by lending to households and businesses based on the lender’s assessment of their ability to pay the loans back.  Insurance companies spread risk among large groups of customers, sparing the focus of hardship on the unlucky few.  Financial advisers help people and businesses save and invest wisely.  Venture capitalists raise funds for entrepreneurs who create innovative products and services.  Hedge funds should not be allowed to exist just to gamble on giant returns by using greater leverage than is allowed of regulated financial institutions.  As a minimum, hedge funds should be regulated with regard to leverage and the transparency of their operations.  If hedge funds cannot find a contributing role in the real economy, they should be shut down.

The new financial order must ensure the independence of the financial rating companies.  We need to separate the funding of financial rating companies (like Moodys, Standard & Poors, and Fitch) from the financial engineers who came to them for ratings.  We have suffered from a system under which bond issuers paid the ratings companies to rate their bonds, and the ratings companies sold consulting services to tell the issuers how to tweak the composition of their Collateralized Debt Obligations to get AAA ratings. The federal government needs to police conflicts of interest like that. [xii] 

Transparency is a key issue.  New Deal legislation sought to increase transparency in the interstate offering and sale of securities.  The Securities Act of 1933 requires every U.S. public company to register new securities (with the SEC after 1934) and to offer (interstate) securities only through a truthful prospectus giving basic financial information as well as stating the risk involved in investing in the offered securities.  Corporations were also required to issue audited annual reports on the status of the business.  The Securities Exchange Act of 1934 focused on the sale of securities in secondary markets, creating the Securities and Exchange Commission (SEC) to monitor and enforce corporate reporting, ensure conformance with regulations, as well as to detect and punish accounting fraud, false information distribution, insider trading or other violations of the securities law.[xiii]  Unfortunately, despite additional legislation (e.g., the Investment Company Act of 1940, the Investment Advisors Act of 1940, and the Sarbanes-Oxley of 2002), federal laws have not kept up with the pace of financial chicanery (described in the industry as innovation).

There needs to be more transparency of all kinds of financial instruments, including the kind of mortgage-backed securities, collateralized debt obligations and credit default swaps that have created the multi-trillion dollar financial meltdown we have experienced over the past eighteen months.  For example, standardized credit default swaps should be traded through a CDS clearinghouse (something that Tim Geithner has been encouraging in recent months). Legislation is needed to establish a streamlined framework for regulating the equity, debt, commodity and derivatives markets.  The functions of the SEC and CFTC, as well as functions undertaken by the Fed and the Treasury on an ad hoc basis, should be transferred to this new regulatory agency.[xiv]

Size is also an issue.  No financial institution should be allowed to grow into a company that it is too big to fail.  Sandy Weill was right when he predicted the repeal of the Glass-Steagall Act after he created Citigroup, but he was also right in what he implied, which was that he had created an institution that had an inherent advantage over its rivals because it was too big to fail.  Citigroup must be broken up.  If the Citigroup management does not spin off parts of its business voluntarily, then antitrust litigation should be used to break up the company.  Furthermore, we need to reverse the trend during the Paulson era of turning to the biggest banks to absorb other big banks that get into trouble.  We must ensure that there are no more Citigroups in the future.

We hope and trust that the new Economic Recovery Advisory Board to be chaired by Paul Volker will address these issues and recommend a new financial system regulatory framework.

Summary

Invoking moral hazard instead of vigorously regulating the financial industry has resulted in the worst financial crisis since the early 1930s.  This site is not alone in saying proper vigorous regulation of the financial industry must replace the concept of minimizing moral hazard as the means for preventing financial crises such as we have been experiencing for the last year and a half.[xv] 

In September 2008, with the worldwide economy teetering on the brink of calamity, Treasury Secretary Hank Paulson decided to reduce moral hazard by standing back, demanding that the financial industry heal itself, and allowing Lehman Brothers to go bankrupt when Barclays Bank could not accept the risks of a takeover.  The result:  Credit markets froze and stock markets crashed all over the world.  In the two months following the Lehman Brothers bankruptcy, the U.S. stock market alone declined approximately $5 trillion in addition to the approximately $3 trillion decline from its peak to the last trading day before the Lehman bankruptcy.  Citigroup tottered on the brink, and needed a federal bailout.  Millions of people will lose their jobs as the recession deepens.  Millions of hard-working people with limited financial acumen have seen their retirement savings deferred or destroyed.

The ad hoc Bush Administration response to the unfolding financial crisis has been guided by its failed laissez faire free market ideology.  Unable to break away from a flawed [Alan Greenspan’s term] ideology, Treasury Secretary Paulson has zigged and zagged from one approach to another as he sought a temporary solution to contain a conflagration that he did not understand. 

Finding a buyer for Bear Stearns was the right thing to do.  Although the terms could have been formulated better, nationalizing Fannie Mae and Freddie Mac was the right thing to do.   Injecting capital into banks was the right thing to do.  Rescuing Citicorp was the right thing to do.  But none of these rescues fix the underlying cause.

To prevent a recurrence of the problems that led to this financial crisis, the United States and indeed the entire world need a new rigorously enforced regulatory structure for the financial services industry.  In the United States, Legislation is needed to establish a streamlined framework for regulating the equity, debt, commodity and derivatives markets.  The functions of the SEC and CFTC, as well as functions undertaken by the Fed and the Treasury on an ad hoc basis, should be transferred to this new regulatory agency.[xvi] 


 

[i] http://www.smartmoney.com/breaking-news/smw/?story=20081124075535

[ii] http://www.pbs.org/newshour/bb/business/july-dec08/citirescue_11-24.html

[iii] http://en.wikipedia.org/wiki/Moral_hazard

[iv] http://www.newyorkfed.org/newsevents/news/markets/2008/rp080324b.html

[v]http://www.nakedcapitalism.com/2008/09/banks-take-bigger-than-estimated-hit-on.html 

[vi] http://www.businessweek.com/investing/insights/blog/

archives/2008/10/lehman_bankrupt.html

[vii]http://www.prospect.org/csnc/blogs/ezraklein_archive?month=09&year=2008&base_name=pointing_fingers

[viii] http://en.wikipedia.org/wiki/Glass-Steagall_Act

[ix] http://en.wikipedia.org/wiki/Citigroup

[x]http://www.prospect.org/cs/articles?article=seven_deadly_sins_of_deregulation_and_three_necessary_reforms

[xi] https://westonpolicy.wordpress.com

[xii]http://www.prospect.org/cs/articles?article=seven_deadly_sins_of_deregulation_and_three_necessary_reforms

[xiii] http://en.wikipedia.org/wiki/U.S._Securities_and_Exchange_Commission

[xiv] https://westonpolicy.wordpress.com

[xv] http://seekingalpha.com/article/95858-moral-hazard-the-demise-of-lehman-brothers

[xvi] https://westonpolicy.wordpress.com

Christopher Shays Blames Fannie and Freddie

October 30, 2008

On Friday afternoon, October 24, I received an email from Christopher Shays’ constituent services asserting the need for Congressional hearings on malfeasance at Fannie Mae and Freddie Mac, for which Congressman Shays blamed the entire financial crisis that has spread from the United States to all parts of the world.  This is an assertion that I have heard repeated several times by John McCain and other Republicans during the past three months. 

While I agree that there was mismanagement at Fannie and Freddie, it was not the main cause of the current financial crisis.  The securitization of subprime loans started on Wall Street, at companies like Bear Stearns.  The creation of credit default swaps to “insure” these mortgage-backed securities started when J.P. Morgan suggested the idea to AIG.  If Fannie and Freddie had never bought, securitized or insured any subprime loans, their revenues would gone down but unregulated mortgage brokers would have just sold their loans to Wall Street firms.

The primary cause of the current financial crisis is deregulation ideology.  In 1994, Congress passed the Home Ownership and Equity Protection Act (HOEPA) giving the Federal Reserve the power and duty to regulate the mortgage lending industry, to require adequate disclosure and prevent predatory lending.  However, Federal Reserve Chairman Alan Greenspan, a lifelong Republican, was reluctant to regulate mortgage lending.  Dr. Greenspan publicly encouraged people to make use of adjustable rate mortgages, which he said would lower the cost of home ownership.

When, in July 1998, the Commodity Futures Trading Commission proposed to regulate OTC financial derivatives such as swaps, SEC Chairman Arthur Levitt objected.  Less than two months later, we almost had a world-wide financial crisis when highly-leveraged LTCM collapsed but was saved by several commercial and investment banks at the instigation of the Treasury and the Federal Reserve.   

Unfortunately, our government leaders learned nothing from the LTCM near-disaster in 1998.  Alan Greenspan persuaded Congress to pass legislation removing from the CFTC the power to regulate financial derivatives.  The OTC derivatives market remained unregulated, providing a means for banks and other financial institutions to skirt capital requirements and increase their leverage.  In 2000, the Federal Reserve established an advisory committee chaired by Walter Shipley, former CEO of Chase Manhattan Bank.  The Shipley panel recommended specific changes in regulatory oversight to improve risk management and to require better disclosures for all financial institutions.  However, Fed Chairman Greenspan chose to ignore the recommendations of the Shipley committee.  Last week, Alan Greenspan admitted to a hostile Congressional Oversight Committee that his deregulatory philosophy had a flaw.  Thanks a lot, Mr. Greenspan.  Ten years too late!

Deregulation ideology continued to prevail in this decade. In 2003, the Federal Government preempted authority from the states when several state Attorneys General tried to investigate and rein in deceptive and fraudulent peddling of subprime mortgages.  In 2004, the SEC held a basement hearing with only representatives of five major investment banks, including Goldman Sachs – led by Hank Paulson, now Treasury Secretary – in attendance, and agreed to relax capital requirements on those banks, and allow them to operate at higher leverage.  Meanwhile, the unregulated credit default swap market grew from $900 billion in 2000 to $62 trillion in 2007, or four times U.S. GDP, threatening the entire global capitalist system.[i]

Treasury Secretary Hank Paulson has been consistently behind the curve in dealing with this financial crisis.  Nationalizing Fannie Mae and Freddie Mac in the waning days of summer (September 7, 2008) was the right thing to do.  However, allowing Lehman Brothers go bankrupt on September 15, 2008 turned out to be a huge mistake. In addition to many thousands of creditors holding its bonds, Lehman had made derivatives deals with 8000 firms, and other firms held credit default swaps with notional value of hundreds of billions that were triggered by the Lehman bankruptcy.  The entangling counterparty risk was enormous, affecting financial institutions as well as individuals all over the world.  Financial institution lost all trust to lend to each other, and the credit crisis reached disaster proportions.  Swap sellers sold equities to raise cash to pay swap buyers, driving down global stock markets.  Now all the Kings’ horses and all the Kings’ men are having great difficulty putting Humpty Dumpty back together again. 

Mr. Shays is proud to say that he is a member of the House Financial Services Committee.  What was Mr. Shays doing to provide oversight and regulatory guidance during the years 2000-2006 when the Republicans controlled Congress as well as the White House, and the credit default swap market was growing out of control?  Did Mr. Shays heed Warren Buffet’s warning that unregulated credit default swaps were weapons of mass destruction?  Did Mr. Shays stand up in the House and urge adoption of the Shipley Committee recommendations on risk management and disclosures of financial institutions?  Was Mr. Shays warning about the dangers of increased leverage at investment banks and hedge funds?  Did Mr. Shays request any hearings in 2003 on the subprime mortgage concerns of the state Attorneys General?  The answer to all these questions is no.

I plan to vote for Jim Himes.  He understands the financial world and the need for regulatory reform.


[i] https://westonpolicy.wordpress.com