Simon Johnson's Blog, page 36

Fed Governor Speaks Out For Stronger Rules

By Simon Johnson

A powerful new voice for financial reform emerged this week – Sarah Bloom Raskin, a governor of the Federal Reserve System. In a speech on Tuesday, she laid out a clear and compelling vision for why the financial system should focus on providing old-fashioned but essential intermediation between savers and borrowers in the nonfinancial sector.

Sadly, she also explained that she is a dissenting voice within the Board of Governors on an essential piece of financial reform, the Volcker Rule. Her colleagues, according to Ms. Raskin, supported a proposed rule that is weaker, i.e., more favorable to the banks; she voted against it in October.

At least on this dimension, financial reform is not fully on track.

Two years after the passage of the landmark Dodd-Frank financial reform legislation, you might imagine that the crucial detailed regulations would already be in place.

But, not so, at least with regard to the Volcker Rule, which is intended to limit the ability of big banks to make large “proprietary” bets. (Proprietary trading is jargon for speculation – betting on asset prices going up and down.)

The basic idea of this is simple and completely compelling. Paul A. Volcker, the former chairman of the Federal Reserve System, has stressed that this measure will help us move away from an arrangement in which the people who run big banks get the upside when they are lucky – and the rest of us are stuck with some enormous, awful bill when things go awry.   Senators Jeff Merkley, Democrat of Oregon, and Carl Levin, Democrat of Michigan, fought long and hard to get meaningful provisions into the legislation. But these still need to be turned into regulations that must be followed.

The final Volcker Rule was due out last week but did not appear. The current expectation is that it will appear at some point in August. (The Fed is one of five regulators involved in setting the Volcker Rule; the others are the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Securities and Exchange Commission.)

As Ms. Raskin explained in her speech, “I view proprietary trading as an activity of low or no real economic value that should not be part of any banking model that has an implicit government backstop.”

Our largest financial institutions are bank holding companies, which include both banks and enormous trading operations. These activities are intermingled deliberately by bank management – and typically with the approval of regulators.

In a recent study released by the Federal Reserve Bank of New York, Dafna Avraham, Patricia Selvaggi and James Vickery found that legal and organizational complexity – for example, measured by total number of corporations within a single global financial institution (think Citigroup or JPMorgan Chase) – has increased greatly in recent years.

These structures are intended to benefit from association with federally guaranteed deposits as well as the broader but more nebulous protection that comes from being perceived – by officials and by markets – as too big to fail. A commercial bank gives trading operations huge financing advantages, in part because they have the implied backing of depositors and taxpayers; this is why so many banks have put their enormous derivatives trading operations in their insured banks.

Goldman Sachs this week announced that it will expand its regulated bank as a way to obtain lower-cost financing. The federal insurance on deposits is a great deal for a high-risk trading operation like Goldman’s, lowering its financing costs by perhaps 200 basis points (two percentage points, an enormous amount in today’s markets).

Without government guarantees, creditors to Goldman would want to be compensated for the risks they are taking. As things now stand, Goldman is receiving a large implicit government – and taxpayer – subsidy. The same is true at all the other large banks.

Marc Jarsulic of Better Markets points out that, during the height of the financial crisis, the largest financial institutions in the country received a great deal of emergency financing to support their securities operations. At its peak in September 2008, this financing amounted to around $430 billion (per day).

Like it or not, our “banks” have become securities trading operations. (For more on this and all other dimensions of the Volcker Rule, see Better Markets’ “Everything You Need to Know About the Volcker Rule.”)

Even Sanford I. Weill, former head of Citigroup – and a previous proponent of “financial supermarkets” – now thinks megabanks should be broken up. He told CNBC’s “Squawk Box” on Wednesday:

“What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, have banks do something that’s not going to risk the taxpayer dollars, that’s not too big to fail.”

What these people are converging on is the view that allowing megabanks with their current scale and scope to speculate makes no sense at all.

Unfortunately, we are all learning that just passing a tough law isn’t enough. Regulators must enforce it. Sadly, it seems that our regulators are likely to implement a Volcker Rule with loopholes that may still allow mega-banks to gamble excessively. On the precise nature of these loopholes, see two very powerful comment letters, from Occupy the S.E.C. and Senators Merkley and Levin.

From the tone and timing of Ms. Raskin’s speech, we can reasonably infer that the loopholes remain a big issue. Ms. Raskin uses the metaphor of guard rails on roads: “I was concerned that the guard rails as crafted could be subject to significant abuse – abuse that would be very hard for even the best supervisors to catch.”

Financial institutions know when they are engaged in proprietary trading, but they can hide it well.

The loss-making JPMorgan Chase trading operation in London was headed by Achilles Macris, a well-known proprietary trader renowned for taking risks.

You do not hire a proprietary trader to run a tame hedging operation; you hire him to gamble. You don’t buy a race car to park it in the garage. And when you race it, you have to be prepared for the inevitable crash.

Jamie Dimon, JPMorgan Chase’s chief executive, by all accounts, knew Mr. Macris and fully understood his skill set. And you pay such a trader for his returns from those gambles.

JPMorgan Chase has still not disclosed the structure of its compensation arrangements in its London office, but the likelihood is that compensation must have been in line with standard proprietary trading compensation.

The best way to prevent proprietary trading – as suggested by Better Markets – would be to tie compensation within the securities subsidiaries of bank holding companies to fees for services and trade-flow commissions. Do not pay traders based on their profit and loss on particular positions, irrespective of whether they or anyone else call that proprietary trading.

This and other meaningful restrictions are not likely to be imposed, at least if Ms. Raskin’s concerns about her colleagues are justified.

More serious problems with global megabanks are heading our way.

This column appeared on Thursday on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

Lump Sum or Annuity?

By James Kwak

Usually the New York Times gives reasonably good financial advice—or, at least it avoids giving really bad advice. Today, however, Paul Sullivan’s column borders on the latter. The question is whether to take a pension payout as a lump sum or as an annuity (a guaranteed, fixed amount per year until you die).

Sullivan’s column isn’t all bad. He talks about the importance of being able to manage your money and the need to be comfortable with risk if you take the lump sum. He also points out the annuity (in this case, based on what GM workers are being offered) isn’t indexed to inflation, which is an important consideration. And he doesn’t come down on one side or the other, although he says he would take the lump sum because, he says, “I would rather control the money myself.”

But there are some serious problems with his discussion. One is the way he discusses control as a good thing. Reams of empirical research have shown that, for the typical individual investor, control is a bad thing. Here’s just one fact: from 1991 through 2010, investors in stock mutual funds earned an annual return of 3.8 percent, while the S&P 500 earned an annual return of 9.1 percent. That’s because investors tend to buy high and sell low (based on past performance), and because they generate transaction fees through excessive trading.

This is a case where individuals are better off tying themselves to the mast, like Odysseus before the Sirens, and making it impossible for themselves to make dumb mistakes. Unfortunately, human beings suffer from optimism bias, so most people think they can do better than the market.

The bigger thing that’s missing, however, is a serious discussion of risk. For the purposes of comparison, start by assuming that the conversion between lump sum and annuity is actuarially fair. (If it isn’t—if, for example, the expected value of the lump sum is much higher than the expected value of the annuity—then that will be a major factor. But that’s not something that the typical individual is going to be able to figure out on her own. And more on that later) In that case, you are being offered two things with the same expected value. But one has much higher risk than the other: your average annual retirement income is highly volatile with the lump sum, while it’s known with certainty with the annuity. Basic finance dictates that between two things with the same expected value, the one with lower risk is better.

Now, some people think that the “risk” is that you will die young and you will lose on the annuity; the lump sum, by contrast, exists today, so it has no risk. But that’s the wrong way to think about it. When it comes to retirement income, the most important priority is making sure you don’t run out of it. The thing you really care about is not cash in hand today, but either your average income in retirement or your minimum income in retirement. An annuity guarantees you won’t run out of money; a lump sum doesn’t, and that’s a lot of risk you’re taking on.

So it only makes sense to take the lump sum if the expected value of the annuity is lower than the expected value of the lump sum—and the more risk-averse you are, the bigger the gap has to be. One reason the EV of the annuity could be low is if you know you are likely to die early. Leaving that aside, however, it’s hard to see what rational basis any retiree could have for thinking that the EV of the lump sum is much higher than the EV of the annuity.

If you want to do the calculations, you can’t assume a 10% return, or an 8% return, or even a 4% return on investing your lump sum. You have to assume a risk-free return (since the annuity is risk-free), meaning the yield on Treasuries of appropriate maturity (ten years is probably about right as an average for a retiree in her sixties, who is likely to live twenty more years), meaning about 1.5%. At that yield, I suspect that most GM retirees could not convert their lump sums into the annuities that they are being offered.

Besides, we know what happens when people take lump sums at retirement: just look at West Virginia (although the problems there went beyond just lump sum payouts). It isn’t pretty.

Can Financial Regulation Be Fixed?

By James Kwak

The tragicomic events of the past few months—the London Whale (what are we up to now, $6 billion), Barclays-Libor, HSBC laundering money have prompted renewed interest in better, stronger regulation of the financial sector. Not that it’s going to go anywhere: it’s an election year, the Republicans have a blocking majority in the House and a blocking minority in the Senate, and they are only going to gain Senate seats in November.

But we’ve been here before. Remember the financial crisis? The Obama administration’s response, codified in the Dodd-Frank Act, could be summed up as “better, stronger regulation”—instead of substantive changes to the industry itself. This misses the basic problem with our regulatory structure, as described by John Kay:

“Regulation that is at once extensive and intrusive, yet ineffective and largely captured by financial sector interests.

“Such capture is sometimes crudely corrupt, as in the US where politics is in thrall to Wall Street money. The European position is better described as intellectual capture. Regulators come to see the industry through the eyes of market participants rather than the end users they exist to serve, because market participants are the only source of the detailed information and expertise this type of regulation requires. This complexity has created a financial regulation industry – an army of compliance officers, regulators, consultants and advisers – with a vested interest in the regulation industry’s expansion.”

The only thing I would disagree with is the characterization of U.S. regulators as “crudely corrupt.” Yes, many Congressmen are “in thrall to Wall Street money,” but when it comes to the staff at the regulatory agencies I think the picture is more complex and closer to the “intellectual capture” that Kay describes in Europe. (This is something we discussed briefly in  13 Bankers and that I cover in more depth in my contribution to  Preventing Capture .)

Kay’s proposal is to replace today’s intricate rules, which only provide employment for loophole-seeking lawyers, with broad fiduciary duty standards. Then, for example, the ABACUS case wouldn’t have hinged on whether the fact that John Paulson was betting against the CDO was material and should have been disclosed, but on whether Goldman was acting in the best interests of its buy-side clients. In practice, the effect would be to make it easier for clients to sue their financial institutions—which might be a good thing, given how toothless the regulators have been over the past few decades.

Felix Salmon, however, builds on Kay to argue that what we really need is a financial services market where reputations matter and firms have an incentive to maintain them. That’s clearly not the world we live in today: Goldman gets a reputation for screwing its customers, but they don’t lose any business because those customers (a) figure it’s just a cost of doing business and (b) don’t have any meaningfully different choices. And to get there, Salmon continues, “we’re going to need to see today’s financial behemoths broken up into many small pieces.”

Better regulation would be great at the margin. So would more highly-paid, highly-motivated regulators. But as Salmon says, “the real problem here isn’t regulatory, and as a result there isn’t a regulatory solution.”

The Federal Reserve And The Libor Scandal

By Simon Johnson

On June 1, 2008, Timothy F. Geithner – then president of the Federal Reserve Bank of New York – sent an e-mail to Mervyn A. King and Paul Tucker, then respectively governor and executive director of markets at the Bank of England. In his note, Mr. Geithner transmitted recommendations (dated May 27, 2008) from the New York Fed’s “Markets and Research and Statistics Groups” regarding “Recommendations for Enhancing the Credibility of Libor,” the London Interbank Offered Rate.

The recommendations accurately summarized the problems with procedures surrounding the construction of Libor – the most important reference interest rate in the world – and proposed some sensible alternative approaches.

This New York Fed memo stands out as a model of clear thinking about the deep governance problems that allowed Libor to become rigged.

At the same time, the timing and content of the memo raises troubling questions regarding the Fed’s own involvement in the Libor scandal – both then and now.

According to the recent order against and settlement with Barclays by the Commodity Futures Trading Commission, the Libor “market” had by 2005 become a hotbed of collusion and price-fixing, in which reported interest rates were being manipulated both up and down to the advantage of individual traders and, sometimes, to benefit the banks that employed them.

These activities were widespread, representing – depending on your reading of the details – some combination of a complete breakdown of compliance and control at Barclays and presumably other banks (mentioned but not yet named by C.F.T.C.) and a pattern of apparent criminal fraud.

The New York Fed was apparently aware of Libor-rigging at some level in 2007 and serious concerns – although presumably not the full details of what the C.F.T.C. later established – had reached the most senior levels of the Federal Reserve System by early 2008.

In response to a question from Senator Pat Toomey, Republican of Pennsylvania, at a hearing on Tuesday of this week, the Fed chairman, Ben S. Bernanke, confirmed that he became aware of Libor-related issues in April 2008 (see Page 23 of the preliminary hearing transcript from Congressional Quarterly’s Transcripts Wire; the other quotations below are from the same source, which is available by subscription only).

There are three questions that Mr. Geithner and his colleagues are likely to face in Congressional testimony on Libor. (The House Financial Services Committee has already announced it will hold hearings.)

First, why didn’t Mr. Geithner tell Mr. King the full depth and motivation for his concerns?

Both Mr. King and Mr. Tucker say they did not learn of accusations of dishonesty until recent weeks. What exactly did Mr. Geithner communicate as the specific context and rationale for his reform memo? Did he really only talk in general and vague terms, rather than about the detailed and apparently credible accusations regarding Barclays?

Officials at this level speak with each other on a regular basis. There was ample opportunity for full sharing of relevant information.

Second, why didn’t the Fed do anything itself about the rigging of Libor, including deliberate misrepresentation of information by people at big banks for material gain – keeping in mind that any action that makes a bank look better should be presumed to boost the bonus of the people involved? This issue also came up in Tuesday’s hearing.

“Senator Toomey: The question is why have we allowed it go on the old way when we knew it was flawed for the last four years, with trillions of dollars of transactions?

Chairman Bernanke: Because the Federal Reserve has no ability to change it. “

Mr. Bernanke emphasized that Libor-rigging is a major problem but was adamant that the Fed bears no responsibility for what has happened, adding:

We have been in communication with the British Bankers’ Association. They made some changes, but not as much as we would like. It is, in fact, it is, you know, it’s not that market participants don’t understand how this thing is collected. It is a freely chosen rate. We’re uncomfortable with it. We’ve talked to the Bank of England.

Mr. Bernanke’s answer raises – but does not address – the central issue. The Federal Reserve is responsible for the “safety and soundness” of the financial system in the United States. Does allowing suspicions of fraud to continue unchecked at the heart of this system help to sustain the credibility and legitimacy of markets? Surely not.

Trust is essential to all financial transactions. When trust evaporates – or is smashed to oblivion through reckless and self-serving behavior at megabanks – the consequences can be dire.

The severity of the financial crisis in fall 2008 can be directly attributed to the collapse of trust among financial institutions. Cheating on Libor was not the only cause of this collapse but – if Mr. Bernanke is right and market participants knew what was going on – it must have contributed to it. Concerns about governance may be tolerated in boom times; when the economy goes sour, investors worry much more about who is hiding problems and may be about to collapse.

The Fed has jurisdiction whenever the safety and soundness of the financial system is at stake. Scott Alvarez, general counsel at the Board of Governors, acknowledged this point in a briefing to Senate staff last week. According to The Financial Times:

“In response to questions from Senate aides, Mr. Alvarez said that the Fed was unable to do more because the alleged manipulation of Libor did not constitute a so-called “safety and soundness” concern – a term used by bank regulators to signify threats to a lender’s viability.”

It is hard to see how Mr. Alvarez and his colleagues could have been more wrong – manipulation of Libor most definitely raises safety and soundness concerns.

Third, why wasn’t the impact of potential Libor-related litigation included in recent stress tests for the American banks that may prove to be involved?

Three American banks take part in Libor panels today – and apparently also during the period in question. (I have asked the British Bankers’ Association to confirm this and other details; they indicated a willingness to help but were not able to respond by my deadline – I will report on their information in a future column.) Bank of America is a member of the United States dollar Libor panel; Citigroup belongs to several of the larger Libor panels (including the United States dollar, the British pound and euro); and JPMorgan Chase is present on 9 of the 10 Libor panels.

One argument now being advanced from some financial circles against large fines for the banks involved is that this would reduce their shareholder capital enough to constitute a risk to the financial system.

More broadly, we do not yet know with whom Barclays personnel colluded – or the full extent of the damage to investors and borrowers. Consequently, no one yet knows the scale of balance-sheet damage that will be done by settlements of Libor-rigging claims.

This could even become a “tobacco moment,” in which an industry is forced to acknowledge its practices have been harmful – and enters into a long-term agreement that changes those practices and provides ongoing financial compensation. Certainly attorneys general from states that have been damaged will be thinking along these lines.

Yet at his conference call with analysts on July 13, JPMorgan Chase’s chief executive, Jamie Dimon, was already discussing the possibility of resuming share buybacks later this year. It is hard to know how the Fed could agree to such reduction in shareholder capital. It is also hard to understand why the Fed continues to allow the payment of bank dividends under these circumstances.

The Libor scandal is different in some ways than other recent financial fiascos; it involves egregious, flagrant criminal conduct, with traders caught red-handed in e-mails and on tape. This is the definition of a “smoking gun.”

It is inexcusable and indefensible if these traders aren’t soon brought to account, facing criminal charges in court. That should be first step, with the full support of the Fed (although it obviously doesn’t run criminal investigations).

As Dennis Kelleher of Better Markets told Eliot Spitzer this week,

“Slapping handcuffs on these traders has to be the next step … handcuffs, squeeze them, handcuffs, squeeze them and move up the chain….  This is an open and shut case….This is egregious criminal conduct….There’s never been any accountability on Wall Street.  Wall Street’s a high-crime area and the criminals are just let to run free. This would never be tolerated anywhere else in America, and it’s time to end the two sets of laws. We apply [one set of] laws to everybody in this country and we pamper Wall Street.”  (See from around 3:29 in this clip:  http://current.com/shows/viewpoint/videos/will-banks-be-held-accountable-for-libor-manipulation/)

This is what should have been done years ago for all the illegal behavior that led up to the crisis.

And the Fed should want this clean-up, in the interest of financial stability and ensuring future economic prosperity. The integrity and legitimacy of markets are at stake.

There are slight glimmers of hope that Fed thinking may be heading in the right direction, at least in thinking about the structure of the problem.

At Tuesday’s hearing, Senator Sherrod Brown, Democrat of Ohio, listed the litany of big banks’ recent wrongdoings and the consequent damage, and told Mr. Bernanke: “So many of our biggest banks are too big to manage and too big regulate. I think this behavior shows they’re too big to manage and too big to regulate.”

Mr. Bernanke’s reply was sensible. “I think the real issue is too big to fail,” he said, adding, “And I think that if banks are really exposed to the discipline of the market that we’ll see some breakups of banks.”

Mr. Bernanke feels that the discipline of the market is already working. This is harder to see, particularly in the light of what we learn about bank behavior in connection with Libor.

Let’s hope he is starting to see issues in the financial sector more clearly: Too big to fail is too big to exist – or to behave in accordance with the law. This is a problem of vast, nontransparent and dangerous government subsidies; the market cannot take care of this by itself.

An edited version of this blog post appeared this morning on the NYT.com’s Economix; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

The Market Has Spoken – And It Is Rigged

By Simon Johnson

In the aftermath of the Barclays rate-fixing scandal, the most surprising reaction has been from people in the financial sector who fully understand the awfulness of what has happened. Rather than seeing this as an issue of law and order, some well-informed people have been drawn toward arguments that excuse or justify the behavior of the Barclays employees.

This is a big mistake, in terms of both the economics at stake and the likely political impact.

The behavior at Barclays has all the hallmarks of fraud, pure and simple – intentional deception for personal gain, causing significant damage to others.

The Commodity Futures Trading Commission nailed the detailed mechanics of this deception in plain English in its “Order Instituting Proceedings” (which is also a settlement and series of admissions by Barclays). Most of the compelling quotes from traders involved this scandal come from the Order, but too few commentators seem to have read the full document. Please look at it now, if you have not done so already.

Barclays has acknowledged that its staff took part in a wide-ranging conspiracy (or perhaps a set of conspiracies) to rig markets – including, but not limited to, any securities for which the price is linked to a particular set of short-term interest rates. The collective term for these rates is the London InterBank Offered Rate, known as Libor, but the use of this nomenclature sometimes hides the fact that there is currently a separate Libor daily for each of 10 currencies at 15 maturities, from overnight to 12 months, according to the British Bankers Association. The notional size of the derivatives involved is on the order of $360 trillion.

Barclays could not have manipulated those rates by themselves – and that is not what the C.F.T.C. found or the basis of the Barclays settlement. Rather, some Barclays employees colluded with people at other banks in a way that, over a period of years, moved Libor rates up and down – depending on what would favor the trading positions of the people and organizations involved.

Each Libor “panel” of banks involves 7 to 18 banks. Participating banks submit the rate at which they can supposedly borrow at a particular maturity and in a specified currency, and an average is calculated (taking out high and low values). No one bank is likely to be able to move the calculated Libor rates by itself.

Once the global financial crisis began to bite, there appears to have been a more systematic manipulation of Libor reporting by Barclays management in a particular direction – downward, to make it seem that the bank was healthier and therefore able to borrow from other banks at a cheaper rate.

George Osborne, Britain’s Chancellor of the Exchequer (the equivalent position to the Secretary of the Treasury) and a Conservative Party member, said recently, “Fraud is a crime in ordinary business; why shouldn’t it be so in banking?” The answer, of course, is that fraud is not allowed in any well-run country.

Anyone who takes personal responsibility seriously should want all those involved to be held accountable – to the full extent of the law in all jurisdictions. Anything that lets individuals escape consequences will further undermine the legitimacy that underpins all markets. Bankers should be leading the charge to clean up their industry.

Nevertheless, five arguments put forward in the last 10 days, singly or collectively, attempt to provide some sort of cover for what happened at Barclays. None of these arguments have any merit.

First, it is argued that this kind of cheating around Libor has been going on for a long time. This may be true, but it is a sad and lame excuse that is unlikely to get anyone off. The bigger question must be: Is the financial sector crooked at its core? Statements about a pattern of behavior only strengthen the case that incentives, culture and organizations are all badly broken at the heart of the world’s financial system.

Second, it is also asserted that “everyone does it.” This is not any kind of defense – try it next time you are accused of fraud. But the perception that many people could be involved is part of the reason why this scandal has legs. A broad range of involvement across the financial sector is consistent with what is in the C.F.T.C. Order – although the full scope of the conspiracies has not yet been made clear.

There are three United States banks involved in Libor panels: JPMorgan Chase, Bank of America and Citigroup. Are they also implicated in some aspect of rigging interest rates and therefore securities prices?

Barclays was the first to settle with the C.F.T.C., presumably enabling investigators to gain better access to information about who else is involved. It would not be a surprise if bigger fish are still to come.

Third, Libor-rigging is defended as a “victimless crime.” This is untrue. Traders at Barclays and other banks gained from this series of manipulations, so someone else lost. That may have been investors, who received lower returns than they would have otherwise. Or it may have been borrowers, who paid higher interest rate and related costs than would have been necessary in an honest market. Other losers are presumably everyone who was effectively overcharged by all the intermediaries involved in crooked behavior.  Some local governments have also lost heavily – and at a time when these losses put pressure on essential services and will tend to increase taxes.

Honest people in the financial sector should be up in arms about the behavior of Barclays and other mega-banks.

Fourth, some contend that it is the regulators’ responsibility and fault that there was cheating on Libor. It is certainly the case that there was regulatory capture at work, i.e., officials in Britain, the United States and perhaps elsewhere should have been paying closer attention. I made exactly this point on National Public Radio, in a discussion with Guy Raz and Matt Taibbi, last Saturday.

The mystique of the financial sector wowed many people – including many prominent policy intellectuals, Democratic and Republican – in the years before 2008. But who does the capturing in regulatory capture? Big banks work long and hard and lobby at many levels to push regulators toward paying less attention.

Fifth, the weakest argument is, “It was only a few basis points, here and there” (where a basis point is a hundredth of a percentage point, i.e., 0.01 percent). Either the Libor reporting process and, consequently, the pricing of derivatives has been corrupted by a criminal conspiracy, or it has not. There is no “just a little” in this context for the enormous global securities market.

Robert E. Diamond Jr., who resigned last week as chief executive of Barclays, reportedly said: “On the majority of days, no requests were made at all” to cheat on Libor. The Economist, which does not make a general habit of criticizing prominent people in the financial sector, observed, “This was rather like an adulterer saying that he was faithful on most days.”

Mr. Diamond has fallen. Who is next? How will this play in American politics? There is still time for politicians on the right and on the left of the political spectrum to get ahead of the issue. Digging in around specious arguments in favor of price-fixing cartels is not the way to go.

Power corrupts, and financial market power has completely corrupted financial markets. Barclays and the other global mega-banks involved in fixing Libor have brought their own industry very low – completely destroying the legitimacy on which sensible financial intermediation needs to be based.

Who trusts a banker at this point? The collateral damage is enormous. Who in their right mind would buy a complex derivative product from Barclays or anyone else implicated in this growing scandal?

An edited version of this blog post appeared this morning on the NYT.com’s Economix; it is used here with permission.  If you would like to reproduce the entire column, please contact the New York Times.

Lie-More As A Business Model

By Simon Johnson.  For more discussion of these issues, listen to NPR’s All Things Considered, July 7, 2012.

On Monday, Bob Diamond – the CEO of Barclays, one of the largest banks in the world – was supposedly the indispensable man, with his supporters claiming he was the only person who could see that global megabank through a growing scandal.  On Tuesday morning Mr. Diamond resigned and the stock market barely blinked – in fact, Barclays’ stock was up 0.3 percent.  As Charles de Gaulle supposedly remarked, “the cemeteries are full of indispensable men.”

Mr. Diamond’s fall was spectacular and complete.  It was also entirely appropriate.

Dennis Kelleher of Better Markets – a financial reform advocacy group – summarized the situation nicely in an interview with the BBC World Service on Tuesday.  The controversy that brought down Mr. Diamond had to do with deliberate and now acknowledged deception by Barclays’ staff with regard to the data they reported for Libor – the London Interbank Offered Rate (with the abbreviation pronounced Lie-Bore).  Mr. Kelleher was blunt: the issue in question is “Lie More” not Libor.  (See also this post on his blog, making the point that this impacts credit transactions with a face value of at least $800 trillion.)

Mr. Kelleher’s words may seem harsh, but they are exactly in line with the recently articulated editorial position of the Financial Times (FT) – not a publication that is generally hostile to the banking sector.  In a scathing editorial last weekend (“Shaming the banks into better ways,” June 28th), the typically nuanced FT editorial writers blasted behavior at Barclays and nailed the broader issue in what it called “a long-running confidence trick”:

“The Barclays affair may lack the spice of some recent banking scandals, involving as it does the rather dry “crime” of misreporting interest rates.  But few have shone such an unsparing light on the rotten heart of the financial system.”

The editorial was exactly right with regard to the cultural problem – within that Barclays it had become acceptable or perhaps even encouraged to provide false information.  It underemphasized, however, the importance of incentives in creating that culture.  The employees of Barclays were doing what they were paid to do – and the latest indications from the company are that none of their bonuses will now be “clawed back”.

Martin Wolf, senior economics columnist at the FT and formerly a member of the UK’s Independent Banking Commission, sees to the core issue:

“banks, as presently constituted and managed, cannot be trusted to perform any publicly important function, against the perceived interests of their staff. Today’s banks represent the incarnation of profit-seeking behaviour taken to its logical limits, in which the only question asked by senior staff is not what is their duty or their responsibility, but what can they get away with.”

This matters because, “Trust is not an optional extra in banking, it is, as the salience of the word “credit” to this industry implies, of the essence.”

As the FT editorial put it, “The bankers involved have betrayed an important public trust – that of keeping an accurate public record of the key market rates that are used to value contracts worth trillions of dollars”.

In the words of Mervyn King, governor of the Bank of England, “the idea that my word is my Libor is dead.”  Translation: No one will believe large banks again when their executives claim they could have borrowed at a particular interest rate – we will need to see actual transaction data, i.e., what they actually paid.  Presumably there should be similar skepticism about other claims made by global megabanks, including whenever they plead that this or that financial reform – limiting their ability to take excessive risk and impose inordinate costs on society – will bring the economy to its knees.  It is all special pleading of one or another, mostly intended to rip off customers or taxpayers or, ideally perhaps, both.

Mr. Kelleher has the economics exactly right.  Global megabanks have an incentive to deceive customers, including both individuals and nonfinancial corporations.  Their size confers both market power and the political power needed to conceal the extent to which they are engage in economic fraud.  The lack of transparency in derivatives markets provides them with an opportunity to cheat, but the abuses are much wider – as the Libor scandal demonstrates.

The rip-off is not just for retail investors; chief financial officers of major corporations who should be up in arms.  Boards of directors and shareholders of companies that buy services from big banks should be asking much harder questions about all kinds of derivatives transactions – and who exactly is served by the terms of such agreements.

As Mr. Kelleher puts it on his blog,

“They like to call themselves “banks,” but they aren’t banks in any traditional sense. They are global behemoths that are not just too-big-to-fail, but also too-big-to-regulate and too-big-to-manage. Take JP Morgan Chase for example. It has a $2.35 trillion balance sheet, more than 270,000 employees worldwide, thousands of legal entities, 554 subsidiaries and, as proved by the recent trading losses in London, a CEO, CFO and management team that has no idea what is going on in their own bank.”

“Let’s hope for the sake of the global financial system, the global economy and taxpayers worldwide that Mr. Diamond’s resignation is the first of many. What is needed is a clean sweep of the executive offices of these too-big-to-fail banks, which are still being governed by the same business model as before the crisis: do whatever they can get away with to get the biggest paychecks as possible. (Remember, CEO Diamond paid himself 20 million pounds last year and was the UK banking leader insisting that everyone stop picking on the banks.)

Lie-more is just the latest example of why that all has to change and the sooner the better”

An edited version of this post appeared on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

The Problem with American Politics

By James Kwak

Or, How the Republicans Get Away with It:

“When Priorities informed a focus group that Romney supported the Ryan budget plan — and thus championed ‘ending Medicare as we know it’ — while also advocating tax cuts for the wealthiest Americans, the respondents simply refused to believe any politician would do such a thing.”

From Robert Draper’s article on Priorities USA Action.

The ObamaCare Tax on the Middle Class

By James Kwak

So the new Republican argument (which Mitt Romney was against before he was in favor of it) is that the individual mandate is an oppressive tax on the middle class. Cute, isn’t it, adopting John Roberts’s argument?

First of all, there’s the little matter that the word “tax” in legal doctrine means something different from the word “tax” in ordinary English. And there’s nothing wrong with that. Plenty of words have precise legal meanings that would be foreign to ordinary English speakers, like “negligent,” “reckless,” “material,” and so on, and billions of dollars turn on those precise legal meanings. But that’s not going to sway many people, so let’s go to the numbers.

If you get health insurance through your employer, the individual mandate doesn’t apply to you. There’s no chance you’ll pay the penalty, so the amount of the “tax” is exactly zero.

If you get health insurance from the government (primarily Medicare or Medicaid), the same thing applies. Your tax: zero.

If you already buy health insurance in the individual market, you can continue buying insurance the same way. The main change is that prices will probably come down (or at least grow more slowly) because of transparent competition in the insurance exchanges. (Curious? Check out what we have in Massachusetts, thanks to RomneyCare.) Your tax: zero.

All right, that covers more than eighty percent of you. What if you’re among the roughly 50 million Americans who are currently uninsured?

The typical uninsured household is a family of three that makes between $25,000 and $50,000 per year, probably around $35,000 (see Table 8). If you are a single parent with two children under eighteen, your penalty for not buying insurance is $1,390.

But: Because your household income is less than 200 percent of the applicable federal poverty level, you also receive a premium credit. At most, you will have to pay 6.3 percent of your income on health insurance, or $2,205. (In addition, you get a 13 percent reduction in the amount of cost sharing under your plan.) So you get to buy a family plan, which would ordinarily cost around $12,000, for just $2,205. That’s a benefit of $10,000.

So here you have a law that offers you $10,000 to buy health insurance (or, put another way, gives you a discount of more than 80 percent), but says that if you decline to buy it you’ll have to pay a penalty of $1,390. You can call that $1,390 a tax if you want, but the real question is: does the law make you better off than you were before? Unless most uninsured families like being uninsured, it’s pretty clear that it does make them better off.

(For a broader analysis of who is subject to the individual mandate, see the simulations by Jonathan Gruber. The answer: almost no one.)

In short: Very few people are even theoretically subject to the tax, and most of them are made much better off by the law, since they are transfer beneficiaries.

How can this be? How can a law make everyone better off? Well, it doesn’t. There is a tax-and-transfer element to the Affordable Care Act. The main people who are paying more are the rich (because of a Medicare payroll tax surcharge) and those with good health plans (because of the excise tax on “Cadillac plans”). In addition, the new spending is financed in part by reductions in Medicare spending; those reductions may or may not result in reduced availability of care for Medicare beneficiaries.

The Affordable Care Act is not painless, and there are definitely taxes involved. But the individual mandate “tax” is not one of them.

Pure Spite

By James Kwak

In my Atlantic column on Thursday, I wrote the following about the Roberts Court’s decision to allow states to opt out of Medicaid expansion without losing their existing Medicaid funding:

“What we are going to see is Republican-controlled state governments refusing to expand Medicaid out of bitter hatred toward President Obama and spite for the working poor who need access to health care.”

For those who aren’t up to speed, the deal is basically this. Medicaid is administered by states (which often outsource it to third parties), but the federal government sets certain minimum coverage requirements that states must meet in order to receive federal funding. Those requirements are pretty low, states can choose not to cover able-bodied adults without children, regardless of their income. The Affordable Care Act required states to dramatically increase their Medicaid coverage, with the federal government kicking in 90 percent of the additional funding required (100 percent in the early years).

So, you’re a Republican state governor. (Assume that your party controls the legislature.) You have some working class households in your state that make, say, $25,000 and don’t get health insurance through work. Currently many of them are uninsured. As governor, you have some obligation to look after their interests, even if it’s not a technical legal obligation. You could buy all of them health insurance (not very good health insurance, mind you, but it’s far better than nothing) at a 90 percent discount because the federal government will pick up the rest of the tab.*

On economic grounds, the decision is obvious: you expand Medicaid. And this is why various commentators have said that, when all the brouhaha dies down, most states will do it.

But the politics are equally clear. Medicaid expansion is the one part of “ObamaCare” that the Supreme Court specifically excused you from. If you expand Medicaid, in your next primary, the Tea Party candidate—buoyed by millions of dollars from Karl Rove and the Koch Brothers, who want Medicaid to be as small as possible—will say that you supported ObamaCare. And, frankly, she will be right: you supported ObamaCare because it was good for the people of your state. But you can’t say that, because that sounds even worse.

It comes down to this: whom do you care about more, the working poor or the Tea Party?

So far, conservative darlings like Scott Walker of Wisconsin and Rick Scott of Florida have been very clear where they stand. They are willing to turn down oodles of federal money on the grounds that they need to kick in ten cents on the dollar to cover people who would otherwise go without health insurance.

You really have to hate poor people a lot to make that decision.

* If you don’t cover them, you are saving the federal government money, but only a small fraction of that money will go to the citizens of your state.

The “Me, Too” Party

By James Kwak

In the current issue of Democracy, Elbert Ventura discusses the history of a problem that I’ve brought up as well: the transformation of the Democratic Party into the party of tax cuts. Except, that with the Republican Party as the real party of Texas-sized tax cuts, the Democrats can never be more than the kid brother, half-hearted, talking-out-of-both-sides-of-its-mouth party of tax cuts.

Ventura points out that the Democrats have always been squeamish about taxes, even in the supposed glory days of the New Deal. But things have gotten worse. As Ventura points out, President Obama’s proposal to raise taxes only on households making over $250,000 per year means that “he would bring back the higher Clinton-era rates for only the top 2 percent of taxpayers.” While that proposal still stands (I think), the recent emphasis on the Buffett Rule means that Obama has shifted the tax discussion up to an income group that is completely foreign to most Americans. (Yet a significant minority of Americans are bitterly against the Buffett Rule. Go figure.)

The economic results are obvious: With both parties allergic to tax revenues, there is little alternative to rising deficits as the dependency ratio gets worse and health care costs increase. The political results are only slightly less obvious. A message of “tax cuts for most people” has little chance against “tax cuts for all,” even if it makes slightly more policy sense.

The underlying problem is that forty years of conservative tax revolt, abetted by twenty years of Democratic me-tooism, have conditioned the public to expect tax cuts as their constitutional right. It will take forty years to reverse this trend and will require the kind of “think tanks,” foundations, and media outlets that conservatives have and liberals don’t. Which is to say it could take forever.