Simon Johnson's Blog, page 38

Jamie Dimon And The Legitimacy Of The Federal Reserve System

By Simon Johnson

There are two diametrically opposed views of how the largest financial companies in our economy operate. On the one hand, there are those like Charles Ferguson, director of the Academy Award-winning documentary “Inside Job” and author of the new book, “Predator Nation.” Mr. Ferguson takes the view that greed and immorality now prevail to an excessive degree at the heart of Wall Street.

Academics and other experts have become corrupted, the responsible regulators have been intellectually captured, and law enforcement officials refuse to act – despite the accumulation of evidence before their eyes.

“Inside Job” was gripping and emotional; “Predator Nation” contains many more specific details and evidence, as this excerpt dealing with academics (one Republican and one Democrat) makes clear.

The second view is that the people in charge of large banks and bank holding companies have done nothing wrong. To see this view in action, look no further than this week’s debate about whether Jamie Dimon, chief executive of JPMorgan Chase, should resign from the board of the Federal Reserve Bank of New York. The New York Fed oversees his organization, including assessing whether it is taking dangerous risks, so there are reasonable questions about whether this creates a potential conflict of interest.

A balanced account of this debate appeared in American Banker, which kindly agreed to bring the entire article out from behind its paywall. The strongest statement from the pro-Dimon corner comes from Ernest Patrikis, a partner with White & Case L.L.P. and former general counsel of the New York Federal Reserve:

“I don’t see Jamie Dimon’s conflict of interest. What’s the conflict? He’s expected to represent the banks’ view, the lenders’ view.”

Yet even people who are generally sympathetic to banks feel that there is a perception problem with Mr. Dimon’s position. Treasury Secretary Timothy Geithner said exactly that to the “PBS NewsHour” last week.

Kenneth Guenther, the former head of the Independent Community Bankers of America, told American Banker:

“I do think there is a public perception problem when the head of the largest bank gets into a massive highly publicized trading loss, which he articulately condemns, when he’s tied to the Federal Reserve Bank of New York, and the president of the Federal Reserve Bank is vice chair of the Federal Open Market Committee. There is a perception problem. I don’t think there’s any way around it.”

What exactly is a conflict of interest? Narrowly defined, an actual conflict of interest would involve using public office for personal financial gain – and would be a matter for criminal prosecution.

There is only one case that I am aware of in which a director of the New York Fed went to prison for such a violation – Robert A. Rough was indicted in December 1988, on charges that he leaked sensitive interest-rate information to a brokerage firm. He was sentenced to six months in prison.

More broadly, however, in modern America we use the term “conflict of interest” when we believe someone may be promoting private interests while acting in a public role.

Allowing big bankers to become too influential is an important part of what Mr. Ferguson writes about. If you don’t understand the channels through which influence actually works in the United States today, you need to see “Inside Job,” which touched a nerve and won an Oscar precisely because it is profoundly undemocratic when powerful people are able behave in this way.

Elizabeth Warren, a Democratic candidate for the Senate in Massachusetts, said Mr. Dimon should resign from the board of the New York Fed. The recent spectacular trading losses at his company require a full investigation, which should include an examination of how the supervision process broke down. How can this be anything other than awkward for the New York Fed while Mr. Dimon – hardly known as a shrinking violet – sits on its board?

Senator Bernie Sanders, independent of Vermont, would go further, proposing legislation that would remove any bankers from the boards of Federal Reserve banks. For more background, you may want to consult Page 65 and other parts of this report from the Government Accountability Office, which deal with potential conflicts of interest in the Federal Reserve System, or at least read Senator Sanders’s summary of the report.

To be clear, directors of the New York Fed are in principle kept away from bank-supervision matters – a point that was codified in December 2010, following the passage of the Dodd-Frank financial reform legislation.

Under the current bylaws, directors are not involved in appointing, monitoring or compensating the head of supervision, although they have input into the selection and remuneration of the head of research (an important position, as this person helps to shape the Fed’s view on bank capital and all technical matters relative to risk management), and they oversee other management issues. Bill Dudley, the president of the New York Fed, interacts with the board at least several times a month, as you can see from his schedule.

Mr. Dudley, a former Goldman Sachs executive, was originally appointed president of the New York Fed by a board that included Mr. Dimon as a voting member.  The Dodd-Frank legislation stripped so-called “Class A” directors, of which Mr. Dimon is one, from voting on such appointments.  Mr. Dudley was subsequently reappointed by the Class B and Class C directors of the board.  (For more on the different classes of directors, see this page)

Mr. Dimon has also been an outspoken opponent of financial reform of late – including the Volcker Rule (on proprietary trading) and attempts to strengthen capital requirements. He is an intensely political figure, despite the fact that an important footnote in the Board of Governors’ policy on political activity by Reserve Bank Directors says,

In all instances, directors should avoid any political activity that would publicly identify the director as being associated with the Federal Reserve System or would embarrass the System or raise questions about the independence of the director or the ability to perform Federal Reserve duties.

Directors are allowed to lobby and engage in other specific activities. The issue is whether these actions undermine the effectiveness of the New York Fed.

There is recent precedent for New York Fed board members resigning when there is a perceived conflict of interest – and when the legitimacy of the Federal Reserve System would undoubtedly have been undermined if they had refused to resign.

Dick Fuld, the chief executive of Lehman Brothers, resigned (on Thursday, September 11, 2008) shortly before his firm collapsed (on September 15, but its last day of business was Friday, September 12) – and presumably because the New York Fed was at the center of intense discussions about who should suffer what kind of losses or get rescued. Did he resign of his own volition or was he encouraged to resign?

Stephen Friedman, then the former chief executive of Goldman Sachs, resigned in early 2009 when it became clear that he had bought Goldman stock after Goldman became a bank and therefore fell under the supervision of the New York Fed.

Mr. Friedman was chairman of the New York Fed at that time. (To be clear, Mr. Friedman was not involved in any of the decisions that saved Goldman in fall 2008, and I am not accusing him of using his public position for personal financial gain.)

For those of you keeping score at home, Mr. Fuld was a Class B director and Mr. Friedman was a Class C director.

If you think Mr. Dimon should resign from the New York Fed, you can express your opinion by signing this on-line petition, which I drafted. (For more background on why he should resign, see this blog post.)

If Mr. Dimon refuses to resign – as seems likely – he can removed by the Board of Governors of the Federal Reserve System (not by his fellow directors at the New York Fed). The petition is therefore addressed to the Board of Governors.

There is an undeniable perception problem. It is damaging the legitimacy of the Federal Reserve. As Treasury Secretary Geithner implied, this must be “addressed” – a great Washington euphemism – by Mr. Dimon leaving the board of the New York Fed.

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.

Jamie Dimon Should Resign From the Board Of The New York Fed

By Simon Johnson

Jamie Dimon, CEO of JP Morgan Chase, is a member of the board of the New York Federal Reserve Bank.  Mr. Dimon’s role there is sometimes presented as “advisory” but he sits on the Management and Budget Committee; here is the committee’s charter, which includes reviewing and endorsing “the framework for compensation of the Bank’s senior executives (Senior Vice President and above)”.  His advice apparently extends to important aspects of how the New York Fed operates, including its personnel policies.

The New York Fed is a key part of our regulatory and supervisory apparatus, involved in overseeing the activities of banks and bank holding companies, like JP Morgan Chase (currently the largest bank in the US).  Within the Federal Reserve System, the New York Fed also has some of the deepest expertise on financial markets and complex products, such as derivatives.  Almost of the relevant supervision takes place behind closed doors, with representatives of the industry – including big banks – typically taking the position that they should be allowed to operate in a particular way or use various kinds of risk models.  The staff of the New York Fed often has a decisive voice in determining what kinds of risks are acceptable for systemically important financial institutions.

In recent weeks, risk management apparently broke down completely at JP Morgan Chase.  Even the most sympathetic accounts portray Mr. Dimon as out of touch with large parts of his business.  There are also press reports that one or more of Mr. Dimon’s hand-picked executives failed to understand and report on risks that became greatly magnified and quickly got out of control.  Puzzles remain about what exactly Mr. Dimon did not know and when he did not know it, including the question of whether he disclosed all adverse material information in a timely and appropriate manner.  Presumably, the New York Fed will be involved – directly or indirectly – in ongoing and future investigations (including answering questions about what its staff did or did not know).

At the end of last week, Treasury Secretary Tim Geithner called for Mr. Dimon to step down from the board of the New York Fed.  Mr. Geithner is former president of the New York Fed and fully understands how the board operates – and how big bankers win friends and influence people.  Mr. Geithner spoke in the usual Treasury Department diplomatic code – he suggested there is a “perception” problem that must be addressed.  To officials, this is as clear a statement as is needed.  As chairman of the Financial Stability Oversight Council, Mr. Geithner is ultimately responsible for the health of the financial system and its systemically important components.  He is telling Mr. Dimon to go.

Mr. Dimon is likely to resist, but the blatant conflicts of interest in the current situation are too great.  Mr. Dimon should not be in any position to influence or affect an organization that plays such an essential role in overseeing the activities of his company.  Given the evident breakdowns in risk management at JP Morgan Chase and the possibility that there were again problems with bank supervision in this instance, we need to have a proper independent investigation – and to changes the parameters of this banker-supervisor relationship going forward.

To have Mr. Dimon involved in overseeing the management of the New York Fed, an organization that oversees his activities, decisions, and potential losses, is no longer acceptable.  We do not accept such conflicts of interest in other parts of American society and we should not accept them in this instance.

The Need For An Independent Investigation Into JP Morgan Chase

By Simon Johnson

JPMorgan Chase is too big to fail. As the largest bank-holding company in the United States, with assets approaching $2.5 trillion as reported under standard American accounting principles, it is inconceivable that JPMorgan Chase would be allowed to collapse now or in the near future. The damage to the American economy and to the world would be too great.

The company’s recent trading losses therefore call for greater public scrutiny than would be case for most private enterprise – and demand an independent investigation into exactly what happened. (Dennis Kelleher of Better Markets has already called for exactly this.) The investigation begun by the F.B.I. is unlikely to be sufficiently public.  Given the strong political connections between JP Morgan and the Obama administration, it would also be better to have an investigation led by a completely independent counsel.

Hopefully, too-big-to-fail is not forever. The Federal Deposit Insurance Corporation is working on a mechanism that could conceivably allow that agency to handle the “failure” of a bank-holding company while protecting the creditors of operating subsidiaries – limiting the potential contagion effect.

But this mechanism is not yet in place, it does not currently apply to cross-border banking (remember that JPMorgan Chase’s losses are in London), and even the F.D.I.C.’s acting chairman, Martin J. Gruenberg, was careful in describing its likely efficacy in a speech last week.

(Disclosure: I’m on the F.D.I.C.’s Systemic Resolution Advisory Committee, and I’ve helped the F.D.I.C. with some outreach activities, designed to help them receive constructive feedback on resolution. I am not paid by the F.D.I.C.)

In effect, JPMorgan Chase operates with the implicit backing of the United States government – primarily in the form of actual and potential access to borrowing from the Federal Reserve, with the implication that the Treasury could also provide support. Being effectively backed by the full faith and credit of the government is a great help; it lowers a bank’s funding costs because it reduces the risk to creditors. JPMorgan Chase and the other big banks in the American economy are effectively government-sponsored (and subsidized) enterprises.

There is no kind of market involved in determining the franchise value of mega-banks; this is a government subsidy scheme, pure and simple. People on the right of the political spectrum understand this, as do people on the left; see my blog post last week on the extent of cross-partisan agreement on this issue.

I would add to that list former Gov. Mike Huckabee of Arkansas. When I appeared on his radio show on Monday afternoon, we were in complete agreement on the need to break up or otherwise constrain the size of big banks.

There are many unanswered questions about the JPMorgan Chase losses and a great deal of informed guesswork about exactly what went wrong. By his own admission, Jamie Dimon, the chief executive, was unaware of what was happening on the relevant trading desk until Bloomberg News reporters brought it to his attention.

At that time he dismissed any concerns as a “tempest in a teapot.” In the weeks that followed, this supposed “hedge” – or risk-reduction strategy – blew up badly.

The question is not why a trader made a mistake; this can happen anywhere. The issue is how this was handled and reported by JPMorgan Chase’s risk-management professionals and their systems – believed by many insiders to be the best in the business.

Here are five questions that an independent investigation should consider:

1. What exactly was the trade? Who approved and reviewed the trade?

2. To what extent were the mistakes encouraged or condoned by particular quantitative models, for example those popularly known as Value-at-Risk? (For a critique, see Pablo Triana’s book, “The Number That Killed Us.”)

3. What did Mr. Dimon know and when did he know it? Was there disclosure to the board and to shareholders with appropriate timing? This is among the specific concerns raised by Mr. Kelleher.

4. Does the board have adequate depth of experience along the relevant dimensions of risk management?

5. What interactions did Mr. Dimon or any of his colleagues have with the Federal Reserve Bank of New York before and during these losses were incurred? Mr. Dimon is on the board of that institution, where his role is described as “advisory.” But on what exactly did he advise them in recent months and years, particularly with regard to risk management and capital levels in systemically important banks?

On the one hand, we hear from bankers that supervisors are watching them closely – and even undermining their business. On the other hand, clearly someone was not paying attention. Why not?

This is not about conducting a witch hunt. It is about establishing the facts and understanding if anything about standard operating procedures and emergency protocols should be examined.

The right analogy is National Transportation Safety Board investigations – a suggestion that has been made by Andrew Lo, my colleague at M.I.T., and his co-authors. We learn a great deal when companies actually go bankrupt; e.g., about Enron (see the excellent book “The Smartest Guys in the Room,” by Bethany McLean and Peter Elkind) and about Lehman (see the bankruptcy examiner’s report).

But we need to investigate near-misses as well.

This is awkward for the White House – look at any of Ben White’s recent pieces on the links between Wall Street and the Obama administration. But the power of big banks on Wall Street makes this kind of investigation even more necessary – see the reporting of Matt Taibbi for some graphic details.

Congress may also want to get involved, at least to understand if Dodd-Frank has been at all helpful. The Volcker Rule is not yet in effect but, if it were, would this have made a difference?

Mr. Dimon contends not, and he has been a consistent and vociferous opponent of the rule from the very beginning. It would seem foolhardy to accept Mr. Dimon’s view on this matter at face value. I testified in favor of the Volcker Rule before the Senate Banking committee in early 2010; Barry Zubrow, then chief risk officer of JPMorgan Chase, testified and strongly opposed it.

Some people in the private sector and within the banking community will push back, asserting that this would further expand the scope of government vis-à-vis legitimate private business. This misses the point — that it is the people who run our largest banks who have undermined the viability of the private sector and who threaten its future.

Cam Fine, president of the Independent Community Bankers of America, has shown strong leadership on this point over the last week (you can follow him @Cam_Fine on Twitter).

In the end, we may well come to the same conclusion as Elizabeth Warren – who has brilliantly seized the political moment and put her opponent for the Massachusetts senate seat, the Republican incumbent Scott Brown, on the defensive.

Ms. Warren is calling for the re-imposition of Glass-Steagall – separating commercial from investment banking. Mr. Fine is already pushing in the same direction. This position should be appealing across the political spectrum.

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

Geithner to Dimon: Resign From The Board Of the New York Fed

By Simon Johnson

In an interview Thursday on PBS NewsHour, Jeffrey Brown and Treasury Secretary Tim Geithner had the following exchange:

“JEFFREY BROWN: Do you think Jamie Dimon should be off the board [of the New York Federal Reserve Board]?

TIMOTHY GEITHNER: Well, that’s a question he’ll have to make and the Fed will have to make. But again, on the basic point, which is it is very important, particularly given the damage caused by the crisis, that our system of oversight and safeguards and the enforcement authorities have not just the resources they need, but they are perceived to be above any political influence and have the independence and the ability to make sure these reforms are tough and effective so we protect the American people, again, from a crisis like this. And we’re going to, we’re going to do that.”

In the diplomatic language of Treasury communications, Mr. Geithner just told Jamie Dimon to resign from the New York Fed board (here is the current board composition).  It looks bad – and it is bad – to have him on the board of this key part of the Federal Reserve System at a time when his bank is under investigation with regard to its large trading losses and the apparent failure of its risk management system.  (Update: Mr. Dimon is on the Management and Budget Committee of the NY Fed board; here is the committee’s charter, which includes reviewing and endorsing “the framework for compensation of the Bank’s senior executives (Senior Vice President and above)”.)

Mr. Geithner’s call is a major and perhaps unprecedented development which can go in one of two ways.

If Mr. Dimon resigns, that is a major humiliation and recognition – at the highest levels of government – that even the country’s best connected banker has overstepped his limits.  This would be a major victory for democracy and a step towards reopening the debate on financial reform, including introducing more restrictions on what global megabanks can do.

In modern American politics, symbols and substance are hard to disentangle.  The big banks have won many rounds, so many times in recent years – including with the help of Mr. Geithner at key moments during the Dodd-Frank debate, in subsequent discussions over capital requirements, and with regard to design and potential implementation of the Volcker Rule (which would limit proprietary trading and other forms of excessive risk taking by big banks).  If Mr. Dimon resigns, this could help open the doors to a broader reevaluation of power in the hands of Too Big To Fail banks – and how they undermine the rest of our economy.

If, as seems more likely, Mr. Dimon stays in place, that would be a great victory for the big banks – and a reminder of who is really in charge of the country.  Mr. Geithner will be forced to walk back from his statement; that would not exactly inspire confidence in our officials – or help President Obama get re-elected.

Keep in mind that Mr. Dimon himself decided to transform the relevant part of JP Morgan Chase into a risk-taking operation – and it is the people he chose and the systems he put in place that have now blown up.

The entire record of recent interactions between JP Morgan Chase and the New York Federal Reserve will presumably be looked at by investigators – including the total number of meetings, the precise content, and the involvement of Mr. Dimon himself.  For example, how often did Mr. Dimon meet with Bill Dudley, president of the New York Fed, over the past 12 months, either one-on-one or in a group meeting?  What exactly was discussed?  How did any of these interactions filter down into the supervisory process?

We need an independent investigation of the JP Morgan losses – as I argued Thursday morning on NYT.com’s Economix blog.  This investigation should examine, among other things, the relationship between Mr. Dimon, his bank, and the New York Fed.

Who will prove more powerful, Jamie Dimon or Tim Geithner?

Why Markets Won’t Fix JPMorgan

By James Kwak

Jonathan Macey, a former professor of mine at Yale Law School,* recently wrote an op-ed for the Wall Street Journal (paywall; excerpts here) arguing that we shouldn’t worry about JPMorgan’s recent trading loss because market forces will ensure that the bank does a better job next time. Here’s a key paragraph:

“Thus, far from serving as a pretext to justify still more regulation of providers of capital, J.P. Morgan’s losses should be treated as further proof that markets work. J.P. Morgan and its competitors will learn from this experience and do a better job of hedging the next time. They will learn because they have to: In the long run their survival depends on it. And in the short run their jobs and bonuses depend on it.”

Macey’s central point is that companies don’t like losing money, so losing $2 billion means that they will do a better job of figuring out how not to lose money in the future. That’s obvious. But it’s also beside the point.

Bankers don’t ask, “Do I want to gain or lose money today?” That’s not the relevant point at which incentives apply. Instead, they ask: “Do I want to engage in this specific class of activities that has a certain expected payout structure?” In the JPMorgan case, the question is: “Do I want to engage in trades that are, roughly, portfolio hedges but that also take significant long or short positions on the credit market as a whole, with the conscious intention of making money?” And what we care about is whether the bankers’ decisions are producing the socially optimal level of risk.

We know that Jamie Dimon pushed the Chief Investment Office to take more risk in pursuit of profits. We also know that the trade in question was not really a true hedge; if it were, there would be no news, because the $2 billion $3 billion loss would have been exactly balanced by a $2 billion $3 billion gain somewhere else, and Dimon wouldn’t be calling his own lieutenants “stupid.”

The problem is that two factors distort bankers’ incentives in the direction of excessive risk-taking (where “excessive” means greater than the socially optimal level). One is that JPMorgan is too big to fail. Macey himself has advocated in the Yale Law Journal for breaking up the largest banks, on exactly the same grounds as the rest of us: banks that are too big to fail have a distorted set of incentives because they can count on the ability to shift losses to the government in a pinch. That means that they have the incentive to engage in riskier activities than they would otherwise.

The other factor is that individual traders have skewed incentives: they get huge bonuses if they their trades make money, with no corresponding downside if their trades lose money. This also encourages bankers to take on excessive risk. And it’s not hard to see that if the payoffs are big enough, the potential loss of your job isn’t going to deter you from taking on that risk.

Now, it’s true, as Steven Davidoff has explained, that the traders in question at JPMorgan may also face clawbacks of their previous stock-based compensation. That is good, because it helps make the incentives symmetric: you get big bonuses if your trades make money, but you lose money you already had if they don’t. But JPMorgan’s clawback policy is a direct result of the reform pressures that resulted from the financial crisis; without the kind of pressure from regulators and reformers that Macey decries, JPMorgan would have no clawback policy at all, and its bankers’ incentives would be even more distorted than they are.

Obviously Jamie Dimon doesn’t like losing money. But he also likes making money, and for that reason he’s going to keep on pushing his people to take on additional risk in pursuit of profits. He can talk all he wants about how this trade went badly, but that doesn’t change the fact that he and his traders want to continue engaging in this class of trades—highly risky, proprietary, macro bets dressed up for as hedges for public consumption. The fact that one went bad is just a cost of doing business. “Markets” aren’t going to solve that problem because those markets are distorted. As long as those distortions exist, JPMorgan’s strategy isn’t going to change.

If you look at Macey’s YLJ article, you’ll see that he and I agree on the big picture: too-big-to-fail distorts incentives and therefore the big banks should be broken up. Do that, and I agree with Macey that we don’t need the Volcker Rule, since at that point I don’t really care what JPMorgan’s Chief Investment Office does, just like I don’t care what Small Hedge Fund X does.

But in this second-best world where we have TBTF banks, we have to do what we can around the edges (like the Volcker Rule) to reduce the distortions they create. Otherwise, losing $3 billion on a “hedge” is not an anomalous mistake that market pressures will eliminate; it’s the natural result of the dominant strategy for TBTF banks and traders with short-term incentives.

* Fans of 13 Bankers owe a debt to Jon Macey, since he was the professor who enabled me to get credit for writing it during my second year of law school.

Because They Can

By James Kwak

It seems as if the Republicans, meaning both John Boehner and Mitt Romney, are trying to turn the national debt back into a major political issue. Now, a visitor from Mars might wonder how this is possible. How could a party that (a) passed the massive tax cuts that were the single largest legislative contributor to today’s record deficits, (b) increased spending rapidly the last time it controlled the federal government, and (c) cannot talk in detail about anything except deficit-increasing tax cuts possibly think that calling attention to deficits could be a political winner?

Well, despite the Republican Party’s abysmal record when it comes to fiscal responsibility, it could still turn out to be smart politics, for a few reasons. One is that many Americans reflexively associate large deficits with excessive spending, even though reductions in tax revenues have played just as big a role since George W. Bush became president. (Compare, for example, receipts and outlays in 2000 and 2011 as a percentage of GDP.) Then they associate excessive spending with Democrats, although the only president to reduce spending significantly in the past forty years was Bill Clinton. It turns out that if you repeat the same tired attack lines year after year—Democrats are all tax and spend liberals, for example—people believe them.

The other, more important reason why Republicans like talking about the national debt is that Democrats don’t have a good response. Sure, Democrats have lots of policy proposals, and theirs make a good deal more sense than the Republicans’; it was President Obama who proposed trillions of dollars in spending cuts and tax increases, which is what people supposedly want (according to opinion surveys, at least).

But most Democrats just don’t like talking about deficits and the national debt. They think it’s a distraction from talking about jobs and unemployment, or they think simply broaching the subject is succumbing to a vast right-wing conspiracy to slash entitlements, or both. The result is that there is no liberal progressive position on the national debt. There’s the Republican one (Romney, Boehner, Ryan), which is to cut taxes (boggle); and there’s the Obama one, which is basically the Republican-Lite position of George H. W. Bush, and which many liberal Democrats run away from. On the left, all there is is a vague belief that you can balance the budget by increasing taxes on the rich, but no one really wants to come out and say it. (Also, the numbers don’t add up unless you’re willing to boost the tax rates on millionaires to very high levels; just, say, repealing the Bush tax cuts for the rich won’t cut it.) Instead, the strategy is to demonize RyanCare, which is effective as a short-term tactic, but doesn’t really amount to a coherent message on the national debt.

This is one reason why I wrote White House Burning. I say “I” because Simon probably wouldn’t call himself a liberal, but I do call myself a liberal, and I think liberals need to have a coherent message on the national debt. I think the message should be something like this: the national debt is a real problem that needs to be addressed; we need to address it in the way that’s best for the American people as a whole; that means preserving the social insurance programs that almost everyone depends on; and we can preserve those programs, while bringing the debt under control, through a set of policy changes that make sense on their own grounds (eliminating distorting subsidies, eliminating tax expenditures, introducing Pigovian  taxes like a carbon tax and a financial activities tax).

You don’t have to agree with our recommendations. But as long as the liberal wing of the Democratic Party has nothing to say about the national debt, conservatives will be free to lead the debate, and the most likely outcome will be some sort of compromise between the moderate Republican Barack Obama an the now-”severe” conservative Mitt Romney. And you can expect the Republicans to bang on this drum from now until November.

Regression to the Mean, JPMorgan Edition

By James Kwak

I haven’t been writing about the JPMorgan debacle because, well, everyone else is writing about it. One theme that has stuck out for me, however, has been everyone’s reflexive surprise that this could happen at JPMorgan, supposedly the best and most competent of the big banks. For example, Lisa Pollock of Alphaville, who has provided some of the most detailed analyses of what happened, asked, “could this really happen under CEO Jamie Dimon’s watch?” Dawn Kopecki and Max Adelson at Bloomberg referred to “JPMorgan’s cultivated reputation for policing risk.” Articles about Ina Drew’s resignation are sure to point out her relative success at dealing with the financial crisis of 2007–2009.

“Highly intelligent women tend to marry men who are less intelligent than they are.” Why? Is it that intelligent men don’t want to compete with intelligent women?

No. It’s mainly because if you take two draws from a random distribution, and the first is at the high end, the second is almost certain to be lower, even if the two are somewhat correlated. This example comes straight from Thinking, Fast and Slow by Daniel Kahneman, which I’m finally reading (chapter 17).

The performance of anyone doing anything will exhibit regression to the mean. If you do well at something, it’s because of some combination of skill and luck. If JPMorgan came through the financial crisis well, it was some combination of skill and luck. Remember, JPMorgan didn’t have as big a portfolio of toxic assets as its competitors because it was late to the party; only in retrospect do we ascribe this good fortune to the supposed skill of Jamie Dimon. JPMorgan was never as good as people (both supporters and critics) made it out to be, so we shouldn’t be so surprised that it just lost $2 billion (and counting).

The more disturbing thing isn’t that commentators fell for this statistical red herring. It’s that people inside JPMorgan seem to have fallen for it, too. This was Dimon’s response to a question about whether the Chief Investment Office was becoming more aggressive, as reported by Bloomberg:

“I wouldn’t call it ‘more aggressive,’ I would call it ‘better,’” Dimon told analysts yesterday. “We added different types of people, talented people and stuff like that.” Until recently, they were careful and successful, he said.

People don’t suddenly go from being good to bad overnight. What happens is they go from lucky to unlucky. They are the same people doing the same things.

“Inside JPMorgan, leadership is stunned by the situation, according to two senior executives,” also as reported by Bloomberg. If that’s true, that’s bad news for all of us. It’s one thing if, as many of us thought, JPMorgan was consciously trying to take on more risk (as has been amply documented, Dimon pushed the Chief Investment Office into profit-seeking trades) while denying it to regulators and the press. That’s what we expect.

It’s another thing if the bank didn’t realize it was taking on risks of this magnitude. That implies that JPMorgan executives had started believing their own hype—that is, they believed that they really were just good, not lucky. And that should make all of us very worried.

Making Banks Small Enough And Simple Enough To Fail

By Simon Johnson

Almost exactly two years ago, at the height of the Senate debate on financial reform, a serious attempt was made to impose a binding size constraint on our largest banks. That effort – sometimes referred to as the Brown-Kaufman amendment – received the support of 33 senators and failed on the floor of the Senate. (Here is some of my Economix coverage from the time.)

On Wednesday, Senator Sherrod Brown, Democrat of Ohio, introduced the Safe, Accountable, Fair and Efficient Banking Act, or SAFE, which would force the largest four banks in the country to shrink. (Details of this proposal, similar in name to the original Brown-Kaufman plan, are in this briefing memo for a Senate banking subcommittee hearing on Wednesday, available through Politico; see also these press release materials).

His proposal, while not likely to immediately become law, is garnering support from across the political spectrum – and more support than essentially the same ideas received two years ago.  This week’s debacle at JP Morgan only strengthens the case for this kind of legislative action in the near future.

The proposition is simple: Too-big-to-fail banks should be made smaller, and preferably small enough to fail without causing global panic. This idea had been gathering momentum since the fall of 2008 and, while the Brown-Kaufman amendment originated on the Democratic side, support was beginning to appear across the aisle. But big banks and the Treasury Department both opposed it, parliamentary maneuvers ensured there was little real debate. (For a compelling account of how the financial lobby works, both in general and in this instance, look for an upcoming book by Jeff Connaughton, former chief of staff to former Senator Ted Kaufman of Delaware.)

The issue has not gone away. And while the financial sector has pushed back with some success against various components of the Dodd-Frank reform legislation, the idea of breaking up very large banks has gained momentum.

In particular, informed sentiment has shifted against continuing to allow very large banks to operate in their current highly leveraged form, with a great deal of debt and very little equity.  There is increasing recognition of the massive and unfair costs that these structures impose on the rest of the economy.  The implicit subsidies provided to “too big to fail” companies allow them to boost compensation over the cycle by hundreds of millions of dollars.  But the costs imposed on the rest of us are in the trillions of dollars.  This is a monstrously unfair and inefficient system – and sensible public figures are increasingly pointing this out (including Jamie Dimon, however inadvertently).

American Banker, a leading trade publication, recently posted a slide show, “Who Wants to Break Up the Big Banks?” Its gallery included people from across the political spectrum, with a great deal of financial sector and public policy experience, along with quotations that appear to support either Senator Brown’s approach or a similar shift in philosophy with regard to big banks in the United States. (The slide show is available only to subscribers.)

According to American Banker, we now have in the “break up the banks” corner (in order of appearance in that feature): Richard Fisher, president of the Federal Reserve Bank of Dallas; Sheila Bair, former chairman of the Federal Deposit Insurance Corporation; Tom Hoenig, a board member of the Federal Deposit Insurance Corporation and former president of the Federal Reserve Bank of Kansas City; Jon Huntsman, former Republican presidential candidate and former governor of Utah; Senator Brown; Mervyn King, governor of the Bank of England; Senator Bernie Sanders of Vermont; and Camden Fine, president of the Independent Community Bankers of America. (I am also on the American Banker list).

Anat Admati of Stanford and her colleagues have led the push for much higher capital requirements – emphasizing the particular dangers around allowing our largest banks to operate in their current highly leveraged fashion. This position has also been gaining support in the policy and media mainstream, most recently in the form of a powerful Bloomberg View editorial.

(You can follow her work and related discussion on this Web site; on twitter she is @anatadmati.)

Senator Brown’s legislation reflects also the idea that banks should fund themselves more with equity and less with debt. Professor Admati and I submitted a letter of support, together with 11 colleagues whose expertise spans almost all dimensions of how the financial sector really operates.

We particularly stress the appeal of having a binding “leverage ratio” for the largest banks. This would require them to have at least 10 percent equity relative to their total assets, using a simple measure of assets not adjusted for any of the complicated “risk weights” that banks can game.

We also agree with the SAFE Banking Act that to limit the risk and potential cost to taxpayers, caps on the size of an individual bank’s liabilities relative to the economy can also serve a useful role (and the same kind of rule should apply to non-bank financial institutions).

Under the proposed law, no bank-holding company could have more than $1.3 trillion in total liabilities (i.e., that would be the maximum size). This would affect our largest banks, which are $2 trillion or more in total size, but in no way undermine their global competitiveness. This is a moderate and entirely reasonable proposal.

No one is suggesting that making JPMorgan Chase, Bank of America, Citigroup and Wells Fargo smaller would be sufficient to ensure financial stability.

But this idea continues to gain traction, as a measure complementary to further strengthening and simplifying capital requirements and generally in support of other efforts to make it easier to handle the failure of financial institutions.

Watch for the SAFE Banking Act to gain further support over time.

This is an updated version of a post that appeared in the NYT.com’s Economix blog on Thursday morning.  If you would like to reproduce the entire post, please contact the New York Times.

 

JP Morgan Debacle Reveals Fatal Flaw In Federal Reserve Thinking

By Simon Johnson

Experienced Wall Street executives and traders concede, in private, that Bank of America is not well run and that Citigroup has long been a recipe for disaster.  But they always insist that attempts to re-regulate Wall Street are misguided because risk-management has become more sophisticated – everyone, in this view, has become more like Jamie Dimon, head of JP Morgan Chase, with his legendary attention to detail and concern about quantifying the downside.

In the light of JP Morgan’s stunning losses on derivatives, announced yesterday but with the full scope of total potential losses still not yet clear (and not yet determined), Jamie Dimon and his company do not look like any kind of appealing role model.  But the real losers in this turn of events are the Board of Governors of the Federal Reserve System and the New York Fed, whose approach to bank capital is now demonstrated to be deeply flawed.

JP Morgan claimed to have great risk management systems – and these are widely regarded as the best on Wall Street.  But what does the “best on Wall Street” mean when bank executives and key employees have an incentive to make and misrepresent big bets – they are compensated based on return on equity, unadjusted for risk?  Bank executives get the upside and the downside falls on everyone else – this is what it means to be “too big to fail” in modern America.

The Federal Reserve knows this, of course – it is stuffed full of smart people.  Its leadership, including Chairman Ben Bernanke, Dan Tarullo (lead governor for overseeing bank capital rules), and Bill Dudley (president of the New York Fed) are all well aware that bankers want to reduce equity levels and run a more highly leveraged business (i.e., more debt relative to equity).  To prevent this from occurring in an egregious manner, the Fed now runs regular “stress tests” to assess how much banks could lose – and therefore how much of a buffer they need in the form of shareholder equity.

In the spring, JP Morgan passed the latest Fed stress tests with flying colors.  The Fed agreed to let JP Morgan increase its dividend and buy back shares (both of which reduce the value of shareholder equity on the books of the bank).  Jamie Dimon received an official seal of approval.  (Amazingly, Mr. Dimon indicated in his conference call on Thursday that the buybacks will continue; surely the Fed will step in to prevent this until the relevant losses have been capped.)

There was no hint in the stress tests that JP Morgan could be facing these kinds of potential losses.  We still do not know the exact source of this disaster, but it appears to involve credit derivatives – and some reports point directly to credit default swaps (i.e., a form of insurance policy sold against losses in various kinds of debt.)  Presumably there are problems with illiquid securities for which prices have fallen due to recent pressures in some markets and the general “risk-off” attitude – meaning that many investors prefer to reduce leverage and avoid high-yield/high-risk assets.

But global stress levels are not particularly high at present – certainly not compared to what they will be if the euro situation continues to spiral out of control.  We are not at the end of a big global credit boom – we are still trying to recover from the last calamity.  For JP Morgan to have incurred such losses at such a relatively mild part of the credit cycle is simply stunning.

The lessons from JP Morgan’s losses are simple.  Such banks have become too large and complex for management to control what is going on.  The breakdown in internal governance is profound.  The breakdown in external corporate governance is also complete — in any other industry, when faced with large losses incurred in such a haphazard way and under his direct personal supervision, the CEO would resign.  No doubt Jamie Dimon will remain in place.

And the regulators also have no idea about what is going on.  Attempts to oversee these banks in a sophisticated and nuanced way are not working.

The SAFE Banking Act, re-introduced by Senator Sherrod Brown on Wednesday, exactly hits the nail on the head.  The discussion he instigated at the Senate Banking Committee hearing on Wednesday can only be described as prescient.  Thought leaders such as Sheila Bair, Richard Fisher, and Tom Hoenig have been right all along about “too big to fail” banks (see my piece from the NYT.com on Thursday on SAFE and the growing consensus behind it).

The Financial Services Roundtable, in contrast, is spouting nonsense – they can only feel deeply embarrassed today.  Continued opposition to the Volcker Rule invites ridicule.  It is immaterial whether or not this particular set of trades by JP Morgan is classified as “proprietary”; all megabanks should be presumed incapable of managing their risks appropriately.

Dennis Kelleher and Better Markets are right about the broad need for implementing Dodd-Frank and they are particularly right about the problems that surround non-transparent derivatives (follow them @bettermarkets for some of the smartest lines and best links as the JP Morgan debacle continues to develop).  The Better Markets press release on Thursday night put the entire situation in a nutshell:

“Jamie Dimon and JP Morgan Chase just proved what anyone not getting a paycheck from a Wall Street bank already knows: gigantic too-big-to-fail banks are too-big-to-manage.”

Anat Admati and her colleagues at Stanford (and her growing band of supporters in the US and around the world) are right about bank capital.  The people in charge of Federal Reserve policy in this regard are dead wrong – perhaps because they spend far too much time talking to Jamie Dimon and his fellow executives, while consistently refusing to engage with their better informed critics.

Ms. Admati skewered Jamie Dimon at length and in detail 18 months ago on exactly these issues.  You must read her original Huffington Post piece.  She has been relentless ever since – see this material.  She was right then and she is right now: we need much higher capital requirements and much simpler rules – focus on limiting leverage.  Big banks should be forced to become smaller – small enough and simple enough to fail.

It is time for the Federal Reserve to move its policy on these issues.

Bad Dividend Math

By James Kwak

While working on a new Atlantic column, I came across this article by Donald Luskin (hat tip Felix Salmon/Ben Walsh) arguing that “Taxmageddon” (the expiration of the Bush tax cuts at the end of the year) will cause the stock market to fall by 30 percent.* His argument is basically this: if the marginal tax rate on dividends increases from 15 percent to 43.4 percent, the after-tax yield falls by 33.4 percent, so stock prices should fall by about the same amount.

Ordinarily I don’t bother with faulty claims like this—there are only so many hours in the day—but it bothered me so much it cost me some sleep last night.

The first problem is the only one that Luskin acknowledges: lots of investors don’t pay taxes on dividends. He mentions pension funds; there are also non-profits and anyone with a 401(k) or IRA. According to Luskin, only about one-quarter of dividends are received by people who will pay the top rate. Maybe they are the marginal investors who set prices, he speculates. Well, maybe. But an increase in the tax rate will make dividend-paying stocks more expensive for them but the same price as before for non-taxpaying investors—so as long as we’re going to stick to theory, the former should sell their stocks to the latter for some price between the two.

More important, the price of a stock (in theory, again) is the discounted present value of its future dividend stream aggregated over an infinite horizon. So we need to know what the tax rates will be in all future years. That’s clearly unknowable. If the tax rate goes up on January 1, 2013, that will give us no information about the tax rate in 2113. On the other hand, it will give us very good information about the tax rate in 2013. And it will give us a little bit of information about the tax rate in 2023. In other words, the informational value of a change in tax rates only affects a small part of the summation you have to do if you want to value a stock by its dividend stream. If a company is going to shut down in 2013, liquidate its assets, and return one massive dividend to shareholders, it affects most of the value. If a company is Facebook and is unlikely to pay dividends for a long time, it affects very little of the value. So the impact of such a change on stock prices will be a lot less than the theoretical 33.4 percent that Luskin calculates.

Then there’s the little matter of markets. Luskin’s article chides the “stock market” for ignoring the upcoming change in tax rates on dividends. How does he know? Did he ask the market? More likely, the market is pricing in the possibility of a change in tax policy. In theory, market prices today should reflect the expected future tax level, which is somewhere between 15 percent and 43.4 percent—closer to which one, we don’t know. This is another reason why the actual impact of a tax increase will be smaller than 33.4 percent; the latter assumes that every single investor today is blindly assuming that the tax rate will remain at 15 percent.  (Actually, since the Medicare surtax is already law, every single investor knows that the tax rate will be at least 18.8 percent, not 15 percent.)

But this is all theory. There is actually a way to test these things. To the extent that a change in the dividend tax rate affects stock prices, it should affect high-dividend stocks more than low-dividend stocks. Even on the theory that the value of a stock is the discounted value of its future dividend stream, for a high-dividend stock, much of that value comes from dividends in the next decade, which are likely to be affected by a change in the tax rate. By contrast, for a company that doesn’t pay dividends, the value of its dividend stream is located far out in the future, where a change in today’s tax rate has little expected impact. So if Luskin is right, the 2003 tax cut (which established the 15 percent rate for dividends) should have caused not only a sharp increase in stock prices but also a sharp increase in the price of value stocks relative to growth stocks.

So, courtesy of Yahoo! Finance, here are the closing prices of the Vanguard Value Index (red), which includes high-dividend stocks, and the Vanguard Growth Index (blue), which includes low-dividend stocks, for November 2002 through May 23 2003, the day the final bill was passed by both houses. The question, though, is when the 2003 tax cut would have affected stock prices. There’s no separation between value and growth stocks around November 5, the day the Republicans won the midterm elections.  (Remember, the Democrats had a Senate majority in 2002.) There’s none around January 28, when President Bush called for tax preferences for dividends in his State of the Union address. There’s no reaction around February 27, when the bill that would cut taxes on dividends was introduced.

Now, there is a separation around May 15, when the Senate version initially  passed. (Passage in the House was assured because of the Republican majority there.) This implies that there was significant uncertainty about whether the bill would pass; when the uncertainty cleared, high-dividend stocks gained relative to low-dividend stocks. Score one for Luskin!

But if there was uncertainty that cleared on May 15, and Luskin is right, then two things should have happened: high-dividend stocks should have gained relative to low-dividend stocks, and all stock prices should have shot up. But that’s not what happened. High-dividend stocks went up; low-dividend stocks went down. Investors’ overall appetite for U.S. stocks didn’t change; at the margin, some realized that after-tax dividend yields had just gone up, so they switched from low-dividend to high-dividend stocks.

By May 23, the last date on that chart, passage was a certainty, so the impact of the tax change should have been 100 percent priced in. Do you see a 30 percent increase? I don’t.

Want more evidence? Here are the same two index funds for December 1 through December 17, 2010, when the dividend tax cut was extended for two years. The extension was in serious doubt until December 6, when Democrats and Republicans reached a compromise agreement. Again, you can see an increase in the price of high-dividend stocks relative to the price of low-dividend stocks, starting around December 6. This indicates that the market was reacting to a significant change in the probability of an extension. But there’s no sharp, 30 percent increase in the overall level of stock prices.

So the tax rate on dividends does seem to have a small but visible impact on the relative price of high- and low-dividend stocks. And it may have a small impact on the overall price level, which would make sense. But 30 percent, or anything close to it, is pure fantasy.

So why all this hysteria about a collapse in the stock market on January 1? Well, here’s one hint, from Luskin’s article:

“If there’s a bargaining failure and the scheduled tax hikes on dividends aren’t stopped, we’ll be sorry we’re spending so much political energy now debating about the ’1%’ and their supposed privileges. It’s the 30% down in the stock market we ought be worrying about.”

This is just another attempt to mask the blatant unfairness of the Bush tax cuts by arguing by arguing that that they are good for all of us (well, at least all of us who own stocks, but that’s a matter for another post). They’re not.

* Luskin also talks about “trillions more in new tax hikes under ObamaCare.” Huh? The revenue provisions of the Affordable Care Act are projected to bring in $520 billion over the next decade; even if you include the revenue-increasing coverage provisions (like the excise tax on high-cost health plans), you only get up to $813 billion. That’s not “trillions,” unless you’re talking about an undiscounted infinite horizon.