Simon Johnson's Blog, page 18

What Might Have Been . . .

By James Kwak

I was reading the plea deal in the SAC case, which was approved by the judge yesterday, and then I started reading the criminal indictment filed by the U.S. Attorney’s Office. What I noticed was how relatively simple it was for the prosecutors to convict SAC Capital for the insider trading committed by its employees. In short, because the firm enabled and benefited from the employees’ crimes, the firm was itself criminally liable.

Looking back at the enormous amount of effort the Southern District has put into Preet Bharara’s crusade against insider trading, you have to wonder what they might have accomplished had they instead targeted, say, fraud committed by Wall Street banks that contributed to the financial crisis. That’s the topic of my new column in The Atlantic. One of the frustrations of post-crisis legal proceedings is that it’s so hard to show that any senior executives themselves committed fraud, since they can usually plead some combination of ignorance and incompetence instead. Failing that, though, the government could have put more resources into flipping lower-level employees and then filing criminal indictments against their banks. Yesterday Bharara claimed, “when institutions flout the law in such a colossal way, they will pay a heavy price.” But only if the Department of Justice chooses to go after them.

The Absurdity of Fifth Third

By James Kwak

No, I’m not talking about the fact that a major bank is named Fifth Third Bank. (As a friend said, why would you trust your money to a bank that seems not to understand fractions?) I’m talking about Fifth Third Bancorp. v. Dudenhoeffer, which was heard by the Supreme Court last week.

The plaintiffs in Fifth Third were former employees who were participants in the company’s defined contribution retirement plan. One of the plan’s investment options was company stock, and the employees put some of their money in company stock. (Most important lesson here: don’t invest a significant portion of your retirement assets in your company’s stock. Remember Enron? Anyway, back to our story.) As you probably guessed, Fifth Third’s stock price fell by 74% from 2007 to 2009—this is a bank, you know—so the plaintiffs lost money in their retirement accounts.

The claim (I’m looking at the 6th Circuit opinion)  is that the people running the retirement plan knew or should have known that Fifth Third stock was overvalued in 2007, and they breached their fiduciary duty to plan participants by continuing to offer company stock as an investment option and by failing to sell the company stock that was owned by the plan. The suit was dismissed in the district court for failure to state a claim, so on review the courts are supposed to accept all the plaintiffs’ allegations as correct.

The serious legal issue in this case has to do with the duty of retirement plan fiduciaries to manage the plan’s assets prudently and for the exclusive benefit of plan participants and beneficiaries (ERISA § 404(a)(1)) and how that applies to an individual account plan that is invested in employer stock, to which the usual diversification requirement does not apply (ERISA § 404(a)(2)). More specifically, it has to do with a “presumption of prudence” that some courts apply in this situation—that is, a presumption that it is prudent for an employer stock ownership plan (ESOP) to continuing investing in company stock.

When you are down in the legal minutiae, this is not a crazy idea; after all, the participant chose the company stock option. But at a higher level, this borders on absurd. If you work at a company, you are already heavily invested in that company. Besides having skills that are particularly useful to that company, there’s the little problem that if the company does badly, you could lose your job. Doubling down by putting your retirement assets in the company is just increasing your risk. (This applies less to retirees, unless you’re drawing other retirement benefits from the company, but then the usual rules about investment diversification still apply.) How could the word “prudent” have anything to do with this practice?

At a higher level, you also have to wonder whether simply having a company stock option counts as prudent management of a retirement plan. ERISA exempts the company stock option itself from the diversification rules, but it doesn’t exempt you from the general duty to manage the plan prudently and for the benefit of participants. Given that diversification is the first rule of investing, it seems to me that the existence of an ESOP within a retirement plan is imprudent to begin with. There is a debate (which I’ve written about here) about whether having a stupid investment menu is exempt from the usual fiduciary duties under ERISA § 404(c), but it certainly shouldn’t be.

In short, if retirement plan fiduciaries actually behaved like fiduciaries, we wouldn’t have ESOPs within retirement plans to begin with. That’s what’s absurd about Fifth Third.

Disability Insurance Basics

By James Kwak

A while back I wrote a post critical of a Planet Money/This American Life episode on disability insurance. Among other things, I thought that the episode made too much of the fact that the number of people on federal disability insurance (SSDI or SSI) has gone up since the financial crisis.

The book I’m currently reading with my daughter at family reading time (she just finished a fictional book about a Polish immigrant girl in a mining community in the late nineteenth century) is Social Insurance: America’s Neglected Heritage and Contested Future, by Theodore Marmor, Jerry Mashaw, and John Pakutka. It’s a pretty good overview of the programs that are typically thought of (at least by the left and center-left) as social insurance in this country. Here’s what they say about recent trends in disability insurance (pp. 166–67):

“It has long been understood by those who study disability insurance that during times of economic distress, the incidence of claimed disability increases. Impairments that might have been overcome during times of economic growth and high rates of employment become the basis for claims of disability. . . . As a recession drags on and jobs are not plentiful, many no doubt make the choice to see if a musculoskeletal malady or a mood disorder qualifies them for disability insurance benefits.”

In the longer term—meaning before the financial crisis—disability rates have been creeping upward. The main reasons are: (1) an aging population; (2) the slow increase in the full retirement age for Social Security, which keeps people on SSDI (as opposed to OASI) longer; and (3) the increasing frequency of musculoskeletal and mood disorder claims (e.g., depression). These are all completely normal things, unless you want to go back to the bad old days when mental illnesses like depression were not considered on pair with physical illnesses. At the margin, there is certainly fraud in the system, but in fact it’s quite hard to get disability benefits, and the standards aren’t getting any more lenient.

Sometimes the real story isn’t all that mysterious.

The Too Big To Fail Subsidy Debate Is Over

By Simon Johnson

No doubt there is still a lot of shouting to come, but this week a team at the International Monetary Fund completely nailed the issue of whether large global banks receive an implicit subsidy courtesy of the American government.   Is there a subsidy, is it large, and how much damage could it end up causing to the broader economy?

The answers, in order, are: yes, there is an implicit subsidy that lowers the funding costs for very large banks; the subsidy is big, with costs of borrowing for these banks lowered by as much as 100 basis points, i.e., 1 percentage point; and yet this large scale of implicit support is small relative to the macroeconomic damage that is likely to be caused by the high leverage and incautious risk-taking that the subsidy encourages.

If anything the IMF’s work provides a conservative (i.e., low) set of estimates.

Still, as I explain in my NYT.com Economix column, I’m a big fan of this work because the Fund’s report is very good on how to handle and reconcile the main alternative methodologies for getting at the issue.

The Fund offers an entirely reasonable approach that sets a very high quality bar. The Government Accountability Office (G.A.O.) is expected to produce a report on TBTF subsidies in the summer; their work now needs to be at least as careful and as comprehensive as that of the IMF. The same applies to the Federal Reserve and anyone in the private sector who attempts to dispute these numbers.

More Pseudo-Contrarianism

By James Kwak

I accidentally glanced at the link to David Brooks’s recent column and—oh my god, is it stupid. You may want to stop reading right here to avoid being exposed to it.

Basically, Brooks says that the Supreme Court’s decision in McCutcheon is pro-democratic because it strengthens political parties relative to “donors and super PACs.” In case you weren’t aware, McCutcheon eliminates the aggregate limits on direct contributions to candidates, parties, and PACs (not super PACs–no such limits exist) but the individual contribution limits still stand—so now you can max out to more candidates and parties than you could before.

First of all, let’s be clear about the practical impact here. In the 2012 cycle, 644 people hit the aggregate limits, and they donated $93 million (to entities governed by aggregate limits). That’s nothing. Sheldon Adelson alone contributed close to $150 million. And the limits on what you can donate to either party’s national committee, or either party’s Senate committee or House committee, still stand.

So basically we’re talking about those very few people who, when asked to contribute to (say) the DCCC, said, “Sorry, I’m maxed out.” At the margin, now some of those people can write the check to the DCCC rather than to some super PAC—although they can also write the check to some candidate, or that candidate’s PAC, and that money isn’t under party control.

In Brooks’s world, this is good because weaker parties make it harder for challengers to unseat incumbents. Huh? Has he seen what is going on over in Republican land? The rise of super PACs is a major reason why extreme right wing candidates, funded by the Club for Growth and FreedomWorks, can threaten far right candidates preferred by the Republican Party.

The big money is in super PACs and 501(c)(4)s not because the super-donors wanted to give money to the parties but couldn’t. It’s there because the super-donors like it that way. They like the anonymity of giving to a 501(c)(4). They like the ability to dictate what a super PAC does, rather than having to compete with other people trying to influence a national party.

Brooks also thinks that the current emphasis on fundraising is a consequence of weak parties: “With the parties weakened, lawmakers have to do many campaign tasks on their own. They have to do their own fundraising and their own kissing up to special interests.”

Correlation, causality. The reason candidates have to raise more money is that they need more money. The reason they need more money is that there is a lot more money in politics. The reasons there is a lot more money is politics are (a) rich people have vastly more money than they did a few decades ago and (b) campaign finance laws now allow those rich people to spend a lot more money on politics. That’s why Barack Obama and Mitt Romney both spent time not just soliciting checks made out to their campaigns, but also appearing at events for their “uncoordinated” coordinated super PACs.

McCutcheon isn’t quite the end of the world, because its immediate practical impact is not as big as that of Citizens United and SpeechNow.org. It is significant as a precedent, since it shows that a majority of the Court is perilously close to tossing out contribution limits altogether, going further down the Citizens United rabbit hole in which corruption doesn’t exist. If justices think that a multi-million-dollar donation to a politician’s uncoordinated super PAC isn’t corruption or the appearance of corruption, then there’s no amount of stupidity they aren’t capable of.

Incidence

By James Kwak

One of the criticism’s of Michael Lewis’s book is that he gets his moral wrong. High-frequency trading doesn’t hurt the little guy, as Lewis claims; instead, it hurts the big guy. The explanation is this: people sitting at their desks buying 100 shares of Apple are getting the current ask, so mainly they care about volume and tight bid-ask spreads. Institutional investors, buy contrast, want to buy and sell huge blocks of shares, and they don’t want the price to move in the process; they are the ones being front-run by the HFTs. Felix Salmon pointed this out, and it’s the subject of an op-ed by Philip Delves Broughton today.

What this leaves out is the question of who ends up being harmed. To figure that out, you have to ask whose money we’re talking about when we say “institutional investor.” If it’s SAC Capital, meaning Steven Cohen’s money, then who cares? But most ordinary people invest—if they are lucky enough to have money to invest—through mutual funds (401(k) plans, for example, are largely invested in mutual funds), and those funds are among the “institutional investors” losing money to HFTs. Another big chunk of institutional money belongs to pension funds. In this case, if the pension fund does poorly, the money may come out of its corporate sponsor in the form of increased contributions—or it may come out of beneficiaries and taxpayers in the form of a bankrupt plan shifting its obligations to the PBGC. Then there are insurance companies: in that case, losses from trading affect shareholders, but if they are systemic across the industry they end up as higher premiums for consumers.

This is not to say that the institutional investors are warm and cuddly and are just passive victims in all of this. I’ve spilled enough ink inveighing against active asset managers, and Salmon points out that the buy side bears its share of blame for being careless with other people’s money. At the end of the day, if HFT harms other people in the markets, it’s just a fraternal spat among capital, and doesn’t affect the fundamental divide in the post-Piketty world. Until a poorly-tested algorithm goes berserk and freezes the financial system, that is.

Citigroup CEO Named To “Key Administration Post”

By Simon Johnson

Just a few short days ago, it looked like Citigroup was on the ropes. The company’s proposal for redistributing capital back to shareholders was rejected by the Board of Governors of the Federal Reserve System. Given the global bank’s repeated fiascos – including most recently the theft of around $400 million from its Mexican unit – it is hardly surprising that the Fed has said “no” (and for the second time in three years).

The idea that Citigroup might now or soon have a viable “living will” now seems preposterous. If top management cannot run sensible financial projections (that’s the Fed’s view; see p.7 of the full report), what is the chance that they can lay out a plausible plan to explain how the company, operating in more than 100 countries worldwide, could be wound down through bankruptcy – without any financial assistance from the government? According to the Dodd-Frank financial reform law, failure to submit a viable living will should result in remedial action by the authorities.

Such action has now been taken: CEO Michael Corbat has been named to a top White House job, with responsibility for helping to develop “financial capability for young Americans.”

Given that today is April 1st, this announcement may seem a fairly obvious canard (along the lines of some previous April Fools’ Posts on this website, including regarding the gold standard last year).

But the White House announcement is dated March 27, 2014 (just as the failed stress test news was breaking) – and it is their media team who use the term “top administration post”. Mr. Corbat’s new job has subsequently been confirmed by the Financial Services Roundtable (roundup email of 03/28/14), and no one knows more about the detailed relationship between Big Finance and government.

Presumably, Mr. Corbat’s appointment will help prepare the next generation of Americans for deep recession, job losses, and dismal prospects due to major miscalculations by Citigroup and other big banks – including what these firms have done, what they are doing now, and what they will do.

The agenda for discussion with current distinguished members of this policy council (full name: President’s Advisory Council on Financial Capability for Young Americans) could also usefully include:

How to pay large bonuses, while also losing a lot of shareholder money (Citigroup has long been a market leader on this dimension, including with Mr. Corbat’s compensation for 2013; Barclays is moving up fast).
How to build a global commercial-industrial company, while drawing on the backing of the Federal Reserve (here Goldman Sachs has a definite edge). Not for nothing, Lloyd Blankfein was named Time Man of the Year in 2010.
How to pay out record fines while also receiving a pay raise.  Mr. Dimon of JP Morgan holds the world record in this event, but Barclays’ own internal assessment suggests they are a contender.

The White House may be onto something. If only we could all behave like top Citigroup executives, as a nation we could become much wealthier – systematically expropriating from investors without any adverse consequences for our careers or even our immediate compensation. This is the kind of logic that won the Institute of International Finance two Nobel prizes in 2011 and that lies behind continued opposition to the Volcker Rule.

At the end of his detailed account of miscalculation and overconfidence among Citigroup executives, published in 1995, Phillip L. Zweig writes (Wriston: Walter Wriston, Citibank, and the Rise and Fall of American Financial Supremacy, p. 3) that,

“Citigroup had essentially lost a decade. But along the way, Reed [then-CEO] and his institution had lost much of their hubris. Because of that, there was finally reason to believe that their near-fatal mistakes would not soon be repeated.”

Executives at Citi and elsewhere definitely learned the lessons of the 1970s and 1980s, but not in the way Mr. Zweig envisaged.

Size is power in the modern American economy. If you are building a bank, executives reasoned in the 1990s and early 2000s, it’s better to make it as big as possible. From a personal point of view, they have been proved right again and again. (From a social point of view, this has proved an unmitigated disaster.)

The truth is Citigroup is now and has long been a badly run company.   It should be euthanized by the market, but continues in existence because it is protected by regulation and regulators against being taken over and broken up into more efficient pieces (with some of the worst businesses simply being closed).

The Citigroup case is fascinating because it suggests the Federal Reserve may now be standing up to at least the weakest (from a management perspective) of the Too Big to Fail US banks.

From a political perspective, what matters is not so much the Fed as the White House.

As with everyone in Washington, watch what they do, not what they say.

And the most important question is: Who is admitted to top policy circles? What kind of experience makes someone into an expert who speaks directly to the president – and into a role model held out for young people to emulate?

Mr. Corbat’s new position confirms that, once again, it doesn’t matter how badly Citigroup did on your watch – the White House will hire you for your supposed expertise in any case.

The Desperation of the Vanishing Middle Class

By James Kwak

I recently finished reading Pound Foolish, by Helaine Olen, which I discussed earlier (while one-third of the way through). The book is a condemnation of just almost every form of personal financial advice out there, from the personal finance gurus (Suze Orman, Dave Ramsey) to the variable annuity salespeople to the peddlers of real estate get-rich-quick schemes to Sesame Street‘s corporate-sponsored financial education programs. (Of them all, Jane Bryant Quinn is one of the few who generally come off as more good than evil.)

A lot of what’s going on is just semi-sleazy entrepreneurs trying to make a buck, taking “advice” that is equal parts routine, wrong, and contradictory and packaging it into attractive-looking books, TV shows, and in-person events. A lot of the rest is marketing by the real financial industry, which either (a) wants to make a show of promoting financial education so people will think they are good or (b) wants to teach people that they need their products. (You pick.)

The underlying problem with financial advice—besides the fact that most of it is wrong, conflicted (in the conflict of interest sense), or covert marketing—is that, even in the best case, it rarely works. The underlying financial problem that most Americans have isn’t that they buy too many lattes or pick the wrong stocks. It’s that they don’t make enough money to begin with, at a time when many necessities like health care and education are getting more expensive. (Measured inflation is low in part because things we don’t need, like fancy electronics, are getting cheaper.) This, as I’ve written before, is the fundamental reason why many people won’t be prepared for retirement. Olen has a similar viewpoint: the blind spot of the personal finance industry, she argues, is its refusal to even consider the macroeconomic factors that are the real problem.

But the big question is why this stuff is so popular. As Olen points out, we haven’t always had a personal finance advice industry, and it’s only recently that financial education has been embraced as the solution to all our problems. One reason, she suggests, is that we live in an age of stagnant real wages and rising inequality. Add that to a culture that fetishizes individualism and rejects government support programs, and you have a market that is ripe for self-proclaimed gurus or self-interested advertising campaigns that claim that you can get ahead by (insert your choice) drinking less coffee, or going into more real estate debt, or buying a variable annuity, or picking the right stocks. The governments (state and federal) that promote financial education are like Marie-Antoinette advising people to eat cake; if they could eat cake in the first place, they wouldn’t need financial education.

Many of the people Olen talked to were too embarrassed by their financial plight to let her use their names in the book. Somehow we ended up blaming ourselves for the fact that we don’t have a decent minimum wage, real national health insurance, subsidized child care that made it easier to hold a job, or long-term unemployment insurance (other than in special circumstances). If we saw individuals’ financial struggles as a political issue—or a class issue—things might be different.

Perhaps The Most Boring Important Topic In Economics

By Simon Johnson

International economic policy making is a contender for the title of “most boring important topic” in economics.  And within the field there is nothing quite as dull as the International Monetary Fund (IMF).  Try getting an article about the Fund on the front page of any newspaper.

And even for aficionados of the Fund, the issues associated with reforming its “quota” and “voting rights” seem arcane – and are fully understood by few.

Dullness in this context is not an accident – it’s a protective wrapping against political interference, particularly by the US Congress.

Now, however, the IMF needs a change in its ownership structure, and the sole remaining holdup is Congress.

The Obama administration let this issue slide for a long while, and then attempted to link it with financial aid being extended to Ukraine.  That attempt failed last week.

In a column for Project Syndicate, I discuss why this matters and what comes next.  Try not to fall asleep.

The Chinese Boom-Bust Cycle

By Simon Johnson

Should we fear some sort of financial crash in China, along the lines of what we saw in 2008 in the US or after 2010 in the euro area?

Given the rate of growth in credit and the expansion of the so-called shadow banking sector over the past five years in China, some sort of financial bust seems hard to avoid.

But this need not be the hard landing seen in more developed countries – and the impact on the world economy will likely be much more moderate.  At the same time, however, bigger problems await in the not-too-distant future.

Peter Boone and I review the details in a column for NYT.com’s Economix blog.