Bill Black suggests that in saving the banks, we have saved the vampires

The inability and unwillingness to correct the corruption and decay in the financial sector led to the current economic decline.  Continued unwillingness and delay will certainly bring a return of the same fruits.  But beyond passive enabling, the Fed and Treasury have actively and substantially enriched the authors of the debacle because of the delusion that these practices are similar to legitimate banking because they are carried out behind the same august facades.

Bill Black here outlines the scope and severity of the ongoing crisis, and points to the ultimate access to levers of power. The ability of the financial sector to block meaningful reform after bringing the world to the brink of a second great depression proves how exceptional its powers are to corrupt nearly every critical sector of American public and economic life. The five largest U.S. banks control roughly half of all bank assets. They use their political and financial power to provide themselves with competitive advantages that allow them to dominate smaller banks.

How the Servant Became a Predator: Finance’s Five Fatal Flaws
by Bill Black
October 13, 2009
New Deal 2.0

What exactly is the function of the financial sector in our society? Simply this: Its sole function is supplying capital efficiently to aid the real economy. The financial sector is a tool to help those that make real tools, not an end in itself. But five fatal flaws in the financial sector’s current structure have created a monster that drains the real economy, promotes fraud and corruption, threatens democracy, and causes recurrent, intensifying crises.

1. The financial sector harms the real economy.

Even when not in crisis, the financial sector harms the real economy. First, it is vastly too large. The finance sector is an intermediary — essentially a “middleman”. Like all middlemen, it should be as small as possible, while still being capable of accomplishing its mission. Otherwise it is inherently parasitical. Unfortunately, it is now vastly larger than necessary, dwarfing the real economy it is supposed to serve. Forty years ago, our real economy grew better with a financial sector that received one-twentieth as large a percentage of total profits (2%) than does the current financial sector (40%). The minimum measure of how much damage the bloated, grossly over-compensated finance sector causes to the real economy is this massive increase in the share of total national income wasted through the finance sector’s parasitism.

Second, the finance sector is worse than parasitic. In the title of his recent book, The Predator State, James Galbraith aptly names the problem. The financial sector functions as the sharp canines that the predator state uses to rend the nation. In addition to siphoning off capital for its own benefit, the finance sector misallocates the remaining capital in ways that harm the real economy in order to reward already-rich financial elites harming the nation. The facts are alarming:

• Corporate stock repurchases and grants of stock to officers have exceeded new capital raised by the U.S. capital markets this decade. That means that the capital markets decapitalize the real economy. Too often, they do so in order to enrich corrupt corporate insiders through accounting fraud or backdated stock options.

• The U.S. real economy suffers from critical shortages of employees with strong mathematical, engineering, and scientific backgrounds. Graduates in these three fields all too frequently choose careers in finance rather than the real economy because the financial sector provides far greater executive compensation. Individuals with these quantitative backgrounds work overwhelmingly in devising the kinds of financial models that were important contributors to the financial crisis. We take people that could be conducting the research & development work essential to the success of our real economy (including its success in becoming sustainable) and put them instead in financial sector activities where, because of that sector’s perverse incentives, they further damage both the financial sector and the real economy. Michael Moore makes this point in his latest film, Capitalism: A Love Story.

• The financial sector’s fixation on accounting earnings leads it to pressure U.S manufacturing and service firms to export jobs abroad, to deny capital to firms that are unionized, and to encourage firms to use foreign tax havens to evade paying U.S. taxes.

• It misallocates capital by creating recurrent financial bubbles. Instead of flowing to the places where it will be most useful to the real economy, capital gets directed to the investments that create the greatest fraudulent accounting gains. The financial sector is particularly prone to providing exceptional amounts of funds to what I call accounting “control frauds“.  Control frauds are seemingly-legitimate entities used by the people that control them as a fraud “weapons.” In the financial sector, accounting frauds are the weapons of choice. Accounting control frauds are so attractive to lenders and investors because they produce record, guaranteed short-term accounting “profits.” They optimize by growing rapidly like other Ponzi schemes, making loans to borrowers unlikely to be able to repay them (once the bubble bursts), and engaging in extreme leverage. Unless there is effective regulation and prosecution, this misallocation creates an epidemic of accounting control fraud that hyper-inflates financial bubbles. The FBI began warning of an “epidemic” of mortgage fraud in its congressional testimony in September 2004. It also reports that 80% of mortgage fraud losses come when lender personnel are involved in the fraud. (The other 20% of the fraud would have been impossible had these fraudulent lenders not suborned their underwriting systems and their internal and external controls in order to maximize their growth of bad loans.)

• Because the financial sector cares almost exclusively about high accounting yields and “profits”, it misallocates capital away from firms and entrepreneurs that could best improve the real economy (e.g., by reducing short-term profits through funding the expensive research & development that can produce innovative goods and superior sustainability) and could best reduce poverty and inequality (e.g., through microcredit finance that would put the “Payday lenders” and predatory mortgage lenders out of business).

• It misallocates capital by securing enormous governmental subsidies for financial firms, particularly those that have the greatest political power and would otherwise fail due to incompetence and fraud.

2. The financial sector produces recurrent, intensifying economic crises here and abroad.

The current crisis is only the latest in a long list of economic crises caused by the financial sector. When it is not regulated and policed effectively, the financial sector produces and hyper-inflates bubbles that cause severe economic crises. The current crisis, absent massive, global governmental bailouts, would have caused the catastrophic failure of the global economy. The financial sector has become far more unstable since this crisis began and its members used their lobbying power to convince Congress to gimmick the accounting rules to hide their massive losses. Secretary Geithner has exacerbated the problem by declaring that the largest financial institutions are exempt from receivership regardless of their insolvency. These factors greatly increase the likelihood that these systemically dangerous institutions (SDIs) will cause a global financial crisis.

3. The financial sector’s predation is so extraordinary that it now drives the upper one percent of our nation’s income distribution and has driven much of the increase in our grotesque income inequality.

4. The financial sector’s predation and its leading role in committing and aiding and abetting accounting control fraud combine to:

• Corrupt financial elites and professionals, and

• Spur a rise in Social Darwinism in an attempt to justify the elites’ power and wealth. Accounting control frauds suborn accountants, attorneys, and appraisers and create what is known as a “Gresham’s dynamic” — a system in which bad money drives out good.  When this dynamic occurs,  honest professionals are pushed out and cheaters are allowed to prosper. Executive compensation has become so massive, so divorced from performance, and so perverse that it, too, creates a Gresham’s dynamic that encourages widespread accounting fraud by both financial firms and firms in the real economy.

As financial sector elites became obscenely wealthy through predation and fraud, their psychological incentives to embrace unhealthy, anti-democratic Social Darwinism surged. While they were, by any objective measure, the worst elements of the public, their sycophants in the media and the recipients of their political and charitable contributions worshiped them as heroic. Finance CEOs adopted and spread the myth that they were smarter, harder working, and more innovative than the rest of us. They repeated the story of how they rose to the top entirely through their own brilliance and willingness to embrace risk. All of their employees weren’t simply above average, they told us, but exceptional. They hated collectivism and adored Ayn Rand.

5. The CEO’s of the largest financial firms are so powerful that they pose a critical risk to the financial sector, the real economy, and our democracy.

The CEOs can directly, through the firm, and by “bundling” contributions of its officers and employees, easily make enormous political contributions and use their PR firms and lobbyists to manipulate the media and public officials. The ability of the financial sector to block meaningful reform after bringing the world to the brink of a second great depression proves how exceptional its powers are to corrupt nearly every critical sector of American public and economic life. The five largest U.S. banks control roughly half of all bank assets. They use their political and financial power to provide themselves with competitive advantages that allow them to dominate smaller banks.

This excessive power was a major contributor to the ongoing crisis. Effective financial and securities regulation was anathema to the CEOs’ ideology (and the greatest danger to their frauds, wealth, and power) and they successfully set out to destroy it. That produced what criminologists refer to as a “criminogenic environment” (an atmosphere that breeds criminal activity) that prompted the epidemic of accounting control fraud that hyper-inflated the housing bubble.

The financial industry’s power and progressive corruption combined to produce the perfect white-collar crimes. They successfully lobbied politicians, for example,  to legalize the obscenity of “dead peasants’ insurance“(in which an employer secretly takes out insurance on an employee and receives a windfall in the event of that person’s untimely death) that Michael Moore exposes in chilling detail. State legislatures changed the law to allow a pure tax scam to subsidize large corporations at the expense of their taxpayers.

Caution: Never Forget the Need to Fix the Real Economy

 Economic reform efforts are focused almost entirely on fixing finance because the finance sector is so badly broken that it produces recurrent, intensifying crises. The latest crisis brought us to the point of global catastrophe, so the focus on finance is obviously rational. But the focus on finance carries a grave risk. Remember, the sole purpose of finance is to aid the real economy. Our ultimate focus needs to be on the real economy, which creates goods and services, our jobs, and our incomes.  The real economy came off the rails at least three decades ago for the great majority of Americans.

We need to commit to fixing the real economy by guaranteeing that everyone willing to work can work and making the real economy sustainable rather than recurrently causing global environmental crises. We must not spend virtually all of our reform efforts on the finance sector and assume that if we solve its defects we will have solved the other fundamental reasons why the real economy has remained so dysfunctional for decades. We need to be work simultaneously to fix finance and the real economy.

William K. Black is an Associate Professor of Economics and Law at the University of Missouri-Kansas City. He is a white-collar criminologist and was a senior financial regulator. He is the author of The Best Way to Rob a Bank is to Own One.

Joseph Stiglitz on Wall Street (from Vanity Fair)

When the current crisis is over, the reputation of American-style capitalism will have taken a beating—not least because of the gap between what Washington practices and what it preaches. Disillusioned developing nations may well turn their backs on the free market, warns Nobel laureate Joseph E. Stiglitz, posing new threats to global stability and U.S. security.

Wall Street’s Toxic Message
By Joseph E. Stiglitz
July 2009

Every crisis comes to an end—and, bleak as things seem now, the current economic crisis too shall pass. But no crisis, especially one of this severity, recedes without leaving a legacy. And among this one’s legacies will be a worldwide battle over ideas—over what kind of economic system is likely to deliver the greatest benefit to the most people. Nowhere is that battle raging more hotly than in the Third World, among the 80 percent of the world’s population that lives in Asia, Latin America, and Africa, 1.4 billion of whom subsist on less than $1.25 a day. In America, calling someone a socialist may be nothing more than a cheap shot. In much of the world, however, the battle between capitalism and socialism—or at least something that many Americans would label as socialism—still rages. While there may be no winners in the current economic crisis, there are losers, and among the big losers is support for American-style capitalism. This has consequences we’ll be living with for a long time to come.

The fall of the Berlin Wall, in 1989, marked the end of Communism as a viable idea. Yes, the problems with Communism had been manifest for decades. But after 1989 it was hard for anyone to say a word in its defense. For a while, it seemed that the defeat of Communism meant the sure victory of capitalism, particularly in its American form. Francis Fukuyama went as far as to proclaim “the end of history,” defining democratic market capitalism as the final stage of social development, and declaring that all humanity was now heading in this direction. In truth, historians will mark the 20 years since 1989 as the short period of American triumphalism. With the collapse of great banks and financial houses, and the ensuing economic turmoil and chaotic attempts at rescue, that period is over. So, too, is the debate over “market fundamentalism,” the notion that unfettered markets, all by themselves, can ensure economic prosperity and growth. Today only the deluded would argue that markets are self-correcting or that we can rely on the self-interested behavior of market participants to guarantee that everything works honestly and properly.

The economic debate takes on particular potency in the developing world. Although we in the West tend to forget, 190 years ago one-third of the world’s gross domestic product was in China. But then, rather suddenly, colonial exploitation and unfair trade agreements, combined with a technological revolution in Europe and America, left the developing countries far behind, to the point where, by 1950, China’s economy constituted less than 5 percent of the world’s G.D.P. In the mid–19th century the United Kingdom and France actually waged a war to open China to global trade. This was the Second Opium War, so named because the West had little of value to sell to China other than drugs, which it had been dumping into Chinese markets, with the collateral effect of causing widespread addiction. It was an early attempt by the West to correct a balance-of-payments problem.

Colonialism left a mixed legacy in the developing world—but one clear result was the view among people there that they had been cruelly exploited. Among many emerging leaders, Marxist theory provided an interpretation of their experience; it suggested that exploitation was in fact the underpinning of the capitalist system. The political independence that came to scores of colonies after World War II did not put an end to economic colonialism. In some regions, such as Africa, the exploitation—the extraction of natural resources and the rape of the environment, all in return for a pittance—was obvious. Elsewhere it was more subtle. In many parts of the world, global institutions such as the International Monetary Fund and the World Bank came to be seen as instruments of post-colonial control. These institutions pushed market fundamentalism (“neoliberalism,” it was often called), a notion idealized by Americans as “free and unfettered markets.” They pressed for financial-sector deregulation, privatization, and trade liberalization.

The World Bank and the I.M.F. said they were doing all this for the benefit of the developing world. They were backed up by teams of free-market economists, many from that cathedral of free-market economics, the University of Chicago. In the end, the programs of “the Chicago boys” didn’t bring the promised results. Incomes stagnated. Where there was growth, the wealth went to those at the top. Economic crises in individual countries became ever more frequent—there have been more than a hundred severe ones in the past 30 years alone.

Not surprisingly, people in developing countries became less and less convinced that Western help was motivated by altruism. They suspected that the free-market rhetoric—“the Washington consensus,” as it is known in shorthand—was just a cover for the old commercial interests. Suspicions were reinforced by the West’s own hypocrisy. Europe and America didn’t open up their own markets to the agricultural produce of the Third World, which was often all these poor countries had to offer. They forced developing countries to eliminate subsidies aimed at creating new industries, even as they provided massive subsidies to their own farmers.

Free-market ideology turned out to be an excuse for new forms of exploitation. “Privatization” meant that foreigners could buy mines and oil fields in developing countries at low prices. It meant they could reap large profits from monopolies and quasi-monopolies, such as in telecommunications. “Liberalization” meant that they could get high returns on their loans—and when loans went bad, the I.M.F. forced the socialization of the losses, meaning that the screws were put on entire populations to pay the banks back. It meant, too, that foreign firms could wipe out nascent industries, suppressing the development of entrepreneurial talent. While capital flowed freely, labor did not—except in the case of the most talented individuals, who found good jobs in a global marketplace.

This picture is, obviously, painted with too broad a brush. There were always those in Asia who resisted the Washington consensus. They put restrictions on capital flows. The giants of Asia—China and India—managed their economies their own way, producing unprecedented growth. But elsewhere, and especially in the countries where the World Bank and the I.M.F. held sway, things did not go well.

And everywhere, the debate over ideas continued. Even in countries that have done very well, there is a conviction among the educated and influential that the rules of the game have not been fair. They believe that they have done well despite the unfair rules, and they sympathize with their weaker friends in the developing world who have not done well at all.

Among critics of American-style capitalism in the Third World, the way that America has responded to the current economic crisis has been the last straw. During the East Asia crisis, just a decade ago, America and the I.M.F. demanded that the affected countries cut their deficits by cutting back expenditures—even if, as in Thailand, this contributed to a resurgence of the aids epidemic, or even if, as in Indonesia, this meant curtailing food subsidies for the starving. America and the I.M.F. forced countries to raise interest rates, in some cases to more than 50 percent. They lectured Indonesia about being tough on its banks—and demanded that the government not bail them out. What a terrible precedent this would set, they said, and what a terrible intervention in the Swiss-clock mechanisms of the free market.

The contrast between the handling of the East Asia crisis and the American crisis is stark and has not gone unnoticed. To pull America out of the hole, we are now witnessing massive increases in spending and massive deficits, even as interest rates have been brought down to zero. Banks are being bailed out right and left. Some of the same officials in Washington who dealt with the East Asia crisis are now managing the response to the American crisis. Why, people in the Third World ask, is the United States administering different medicine to itself?

Many in the developing world still smart from the hectoring they received for so many years: they should adopt American institutions, follow our policies, engage in deregulation, open up their markets to American banks so they could learn “good” banking practices, and (not coincidentally) sell their firms and banks to Americans, especially at fire-sale prices during crises. Yes, Washington said, it will be painful, but in the end you will be better for it. America sent its Treasury secretaries (from both parties) around the planet to spread the word. In the eyes of many throughout the developing world, the revolving door, which allows American financial leaders to move seamlessly from Wall Street to Washington and back to Wall Street, gave them even more credibility; these men seemed to combine the power of money and the power of politics. American financial leaders were correct in believing that what was good for America or the world was good for financial markets, but they were incorrect in thinking the converse, that what was good for Wall Street was good for America and the world.

It is not so much Schadenfreude that motivates the intense scrutiny by developing countries of America’s economic failure as it is a real need to discover what kind of economic system can work for them in the future. Indeed, these countries have every interest in seeing a quick American recovery. What they know is that they themselves cannot afford to do what America has done to attempt to revive its economy. They know that even this amount of spending isn’t working very fast. They know that the fallout from America’s downturn has moved 200 million additional people into poverty in the span of just a few years. And they are increasingly convinced that any economic ideals America may espouse are ideals to run from rather than embrace.

Why should we care that the world has become disillusioned with the American model of capitalism? The ideology that we promoted has been tarnished, but perhaps it is a good thing that it may be tarnished beyond repair. Can’t we survive—even do just as well—if not everyone adheres to the American way?

To be sure, our influence will diminish, as we are less likely to be held up as a role model, but that was happening in any case. America used to play a pivotal role in global capital, because others believed that we had a special talent for managing risk and allocating financial resources. No one thinks that now, and Asia—where much of the world’s saving occurs today—is already developing its own financial centers. We are no longer the chief source of capital. The world’s top three banks are now Chinese. America’s largest bank is down at the No. 5 spot.

The dollar has long been the reserve currency—countries held the dollar in order to back up confidence in their own currencies and governments. But it has gradually dawned on central banks around the world that the dollar may not be a good store of value. Its value has been volatile, and declining. The massive increase in America’s indebtedness during the current crisis, combined with the Federal Reserve Board’s massive lending, has heightened anxieties about the future of the dollar. The Chinese have openly floated the idea of inventing some new reserve currency to replace it.

Meanwhile, the cost of dealing with the crisis is crowding out other needs. We have never been generous in our assistance to poor countries. But matters are getting worse. In recent years, China’s infrastructure investment in Africa has been greater than that of the World Bank and the African Development Bank combined, and it dwarfs America’s. African countries are running to Beijing for assistance in this crisis, not to Washington.

But my concern here is more with the realm of ideas. I worry that, as they see more clearly the flaws in America’s economic and social system, many in the developing world will draw the wrong conclusions. A few countries—and maybe America itself—will learn the right lessons. They will realize that what is required for success is a regime where the roles of market and government are in balance, and where a strong state administers effective regulations. They will realize that the power of special interests must be curbed.

But, for many other countries, the consequences will be messier, and profoundly tragic. The former Communist countries generally turned, after the dismal failure of their postwar system, to market capitalism, replacing Karl Marx with Milton Friedman as their god. The new religion has not served them well. Many countries may conclude not simply that unfettered capitalism, American-style, has failed but that the very concept of a market economy has failed, and is indeed unworkable under any circumstances. Old-style Communism won’t be back, but a variety of forms of excessive market intervention will return. And these will fail. The poor suffered under market fundamentalism—we had trickle-up economics, not trickle-down economics. But the poor will suffer again under these new regimes, which will not deliver growth. Without growth there cannot be sustainable poverty reduction. There has been no successful economy that has not relied heavily on markets. Poverty feeds disaffection. The inevitable downturns, hard to manage in any case, but especially so by governments brought to power on the basis of rage against American-style capitalism, will lead to more poverty. The consequences for global stability and American security are obvious.

There used to be a sense of shared values between America and the American-educated elites around the world. The economic crisis has now undermined the credibility of those elites. We have given critics who opposed America’s licentious form of capitalism ample ammunition to preach a broader anti-market philosophy. And we keep giving them more and more ammunition. While we committed ourselves at a recent G-20 meeting not to engage in protectionism, we put a “buy American” provision into our own stimulus package. And then, to soften the opposition from our European allies, we modified that provision, in effect discriminating against only poor countries. Globalization has made us more interdependent; what happens in one part of the world affects those in another—a fact made manifest by the contagion of our economic difficulties. To solve global problems, there must be a sense of cooperation and trust, including a sense of shared values. That trust was never strong, and it is weakening by the hour.

Faith in democracy is another victim. In the developing world, people look at Washington and see a system of government that allowed Wall Street to write self-serving rules which put at risk the entire global economy—and then, when the day of reckoning came, turned to Wall Street to manage the recovery. They see continued re-distributions of wealth to the top of the pyramid, transparently at the expense of ordinary citizens. They see, in short, a fundamental problem of political accountability in the American system of democracy. After they have seen all this, it is but a short step to conclude that something is fatally wrong, and inevitably so, with democracy itself.

The American economy will eventually recover, and so, too, up to a point, will our standing abroad. America was for a long time the most admired country in the world, and we are still the richest. Like it or not, our actions are subject to minute examination. Our successes are emulated. But our failures are looked upon with scorn. Which brings me back to Francis Fukuyama. He was wrong to think that the forces of liberal democracy and the market economy would inevitably triumph, and that there could be no turning back. But he was not wrong to believe that democracy and market forces are essential to a just and prosperous world. The economic crisis, created largely by America’s behavior, has done more damage to these fundamental values than any totalitarian regime ever could have. Perhaps it is true that the world is heading toward the end of history, but it is now sailing against the wind, on a course we set ourselves.

Joseph E. Stiglitz, a Nobel Prize–winning economist, is a professor at Columbia University.

Chris Whalen and Derivatives Regulation

My takeaway from this is that banks involved in this sort of gaming are not producing anything or supporting production, but are simply a drain on the rest of the economy. Supporting them in this effort is only stretching out the problem.

Whalen is as good as there is on banks. When he strays into economics, like most bankers, he gets lost. But here he is very good.

Now from his prepared testimony, link here:

quoting:

When you think about OTC derivatives, you must include both conventional interest rate and currency swap contracts, single name credit default swap or “CDS” contracts, and the panoply of specialized, customized gaming contracts for everything and anything else that can be described, from the weather to sports events to shifting specific types of risk exposure from one unit of AIG to another. You must also include the family of complex structured financial instruments such as mortgage securitizations and collateralized debt obligations or “CDOs,” for these too are OTC “derivatives” that purport to derive their “value” from another asset or instrument.

2) Bank Business Models & OTC

Perhaps the most important issue for the Committee to understand is that the structure of the OTC derivatives market today is a function of the flaws in the business models of the largest dealer banks, including JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS). These flaws are structural, have been many decades in the making, and have been concealed from the Congress by the Fed and other financial regulators.

The fact that today OTC derivatives trading is the leading source of profits and also risk for many large dealer banks should tell the Congress all that it needs to know about the areas of the markets requiring immediate reform. Many cash and other capital markets operations in these banks are marginal in terms of return on invested capital, suggesting that banks beyond a certain size are not only too risky to manage – but are net destroyers of value for shareholders and society even while pretending to be profitable.

Simply stated, the supra-normal returns paid to the dealers in the closed OTC derivatives market are effectively a tax on other market participants, especially investors who trade on open, public exchanges and markets. The deliberate inefficiency of the OTC derivatives market results in a dedicated tax or subsidy meant to benefit one class of financial institutions, namely the largest OTC dealer banks, at the expense of other market participants. Every investor in the global markets pay the OTC tax via wider bid-offer spreads for OTC derivatives contracts than would apply on an organized exchange.

The taxpayers in the industrial nations also pay a tax through periodic losses to the system caused by the failure of the victims of OTC derivatives and complex structured assets such as AIGs and Citigroup (NYSE:C). And most important, the regulators who are supposed to protect the taxpayer from the costs of cleaning up these periodic loss events are so captive by the very industry they are charged by law to regulate as to be entirely ineffective. As the Committee proceeds in its deliberations about reforming OTC derivatives, the views of the existing financial regulatory agencies and particularly the Federal Reserve Board and Treasury, should get no consideration from the Committee since the view of these agencies are largely duplicative of the views of JPM and the large OTC dealers .

3) Basis Risk & Derivatives:

The entire family of OTC derivatives must be divided into types of contracts for which there is a clear, visible cash market and those contracts for which the basis is obscure or non-existent. A currency or interest rate or natural gas swap OTC contract are clearly linked to the underlying cash markets or the “basis” of these derivative contracts, thus both buyers are sellers have reasonable access to price information and the transaction meets the basic test of fairness that has traditionally governed American financial regulation and consumer protection.

With CDS and more obscure types of CDOs and other complex mortgage and loan securitizations, however, the basis of the derivative is non-existent or difficult/expensive to observe and calculate, thus the creators of these instruments in the dealer community employ “models” that purport to price these derivatives. The buyer of CDS or CDOs has no access to such models and thus really has no idea whatsoever how the dealer valued the OTC derivative. More, the models employed by the dealers are almost always and uniformly wrong, and are thus completely useless to value the CDS or CDO. The results of this unfair, deceptive market are visible for all to see – and yet the large dealers, including JPM, BAC and GS continue to lobby the Congress to preserve the CDS and CDO markets in their current speculative form.


In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate US securities and anti-fraud laws. That is, if an OTC derivative contract lacks a clear cash basis and cannot be valued by both parties to the transaction with the same degree of facility and transparency as cash market instruments, then the OTC contact should be treated as fraudulent and banned as a matter of law and regulation. Most CDS contracts and complex structured financial instruments fall into this category of deliberately fraudulent instruments for which no cash basis exists.

What should offend the Congress about the CDS market is not just that it is deceptive by design, which it is; not just that it is a deliberate evasion of established norms of transparency and safety and soundness, norms proven in practice by the great bilateral cash and futures exchanges over decades; not that CDS is a retrograde development in terms of the public supervision and regulation of financial markets, something that gets too little notice; and not that CDS is a manifestation of the sickly business models inside the largest zombie money center banks, business values which consume investor value in multi-billion dollar chunks. No, what should bother the Congress and all Americans about the CDS market is that is violates the basic American principle of fairness and fair dealing.

...

To that point, consider the judgment of Benjamin M. Friedman, writing in The New York Review of Books on May 28, 2009, "The Failure of the Economy & the Economists." He describes the CDS market in a very concise way and in layman's terms. I reprint his comments with the permission of NYRB:

"The most telling example, and the most important in accounting for today's financial crisis, is the market for credit default swaps. A CDS is, in effect, a bet on whether a specific company will default on its debt. This may sound like a form of insurance that also helps spread actual losses of wealth. If a business goes bankrupt, the loss of what used to be its value as a going concern is borne not just by its stockholders but by its creditors too. If some of those creditors have bought a CDS to protect themselves, the covered portion of their loss is borne by whoever issued the swap.

"But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe-as would have happened if the government had not bailed out the insurance company AIG-the consequences might impose billions of dollars' worth of economic costs that would not have occurred otherwise.

"This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today's immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts-including not just banks but insurance companies like AIG-from making such bets in the future. It is hard to see why they should be able to count on taxpayers' money if they have bet the wrong way. But here as well, no one seems to be paying attention."

4) CDS & Systemic Risk

While an argument can be made that currency, interest rate and energy swaps are functionally interchangeable with existing forward instruments, the credit derivative market raises a troubling question about whether the activity creates value or helps manage risk on a systemic basis. It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system. Simply stated, CDS and CDO markets currently are parasitic. These market subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants.

Seen in this context, AIG was the most visible “sucker” identified by Wall Street, an easy mark that was systematically targeted and drained of capital by JPM, GS and other CDS dealers, in a striking example of predatory behavior. Treasury Secretary Geithner, acting in his previous role of President of the FRBNY, concealed the rape of AIG by the major OTC dealers with a bailout totaling into the hundreds of billions in public funds.

Indeed, it is my view that every day the OTC CDS market is allowed to continue in its current form, systemic risk increases because the activity, on net, consumes value from the overall market - like any zero sum, gaming activity. And for every large, overt failure in the CDS markets such as AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets. The only beneficiaries of the current OTC market for derivatives are JPM, GS and the other large OTC dealers.

Stiglitz: Wall Street Hypocrisy, Business as Usual

In a note available at Project Syndicate, Joseph Stiglitz reminds us of the ineptness, sometimes tragic ineptness, of Wall Street and the IMF. This account bears strikingly synchronous tones to our recent "The Economic Fallacy of Free Trade" in the PolicyIndex.

Ten years after the Asian Currency Crisis ...

.... Looking back at the crisis a decade later, we can see more clearly how wrong the diagnosis, prescription, and prognosis of the IMF and United States Treasury were. The fundamental problem was premature capital market liberalization. It is therefore ironic to see the US Treasury Secretary once again pushing for capital market liberalization in India – one of the two major developing countries (along with China) to emerge unscathed from the 1997 crisis.

It is no accident that these countries that had not fully liberalized their capital markets have done so well. Subsequent research by the IMF has confirmed what every serious study had shown: capital market liberalization brings instability, but not necessarily growth. (India and China have, by the same token, been the fastest-growing economies.) Of course, Wall Street (whose interests the US Treasury represents) profits from capital market liberalization: they make money as capital flows in, as it flows out, and in the restructuring that occurs in the resulting havoc. In South Korea, the IMF urged the sale of the country’s banks to American investors, even though Koreans had managed their own economy impressively for four decades, with higher growth, more stability, and without the systemic scandals that have marked US financial markets with such frequency. ....

The contrast between the IMF/US Treasury advice to East Asia and what has happened in the current sub-prime debacle is glaring. East Asian countries were told to raise their interest rates, in some cases to 25%, 40%, or higher, causing a rash of defaults. In the current crisis, the US Federal Reserve and the European Central Bank cut interest rates.

Similarly, the countries caught up in the East Asia crisis were lectured on the need for greater transparency and better regulation. But lack of transparency played a central role in this past summer’s credit crunch; toxic mortgages were sliced and diced, spread around the world, packaged with better products, and hidden away as collateral, so no one could be sure who was holding what. And there is now a chorus of caution about new regulations, which supposedly might hamper financial markets (including their exploitation of uninformed borrowers, which lay at the root of the problem.) Finally, despite all the warnings about moral hazard, Western banks have been partly bailed out of their bad investments.

Following the 1997 crisis, there was a consensus that fundamental reform of the global financial architecture were needed. But, while the current system may lead to unnecessary instability, and impose huge costs on developing countries, it serves some interests well. It is not surprising, then, that ten years later, there has been no fundamental reform. Nor, therefore, is it surprising that the world is once again facing a period of global financial instability, with uncertain outcomes for the world’s economies.

...

There's more. Read it and weep.

Toxic paper comes to State funds

State pension funds and general operating funds nationwide have apparently invested in the toxic paper produced by the unregulated financial markets, according to Joseph Mason, associate professor of finance at Drexel University.

On Bloomberg, Mason made some bone-jarring revelations.

• The CDOs and structured debt for corporations that have similar weaknesses could plague the economy into 2012 and beyond.


• Subprime mortgages are not the only debt with resets to be packaged and sliced (tranched) for the investing animal. Corporate debt, too, has resets coming due.
  


• Why was the contagion in credit markets not confined to subprime? Corporate borrowers are on the hook for the same sorts of problems. This is not invisible to those on the inside. (That is three bullets on the same point. But it begins to reveal why credit markets are seizing up when the problem is advertised to reside only in CDO's holding subprime loans.)
  


• $40 billion has been written down so far, out of at least $400 billion. These resets will be cleared by the end of 2009.
  


• Not only is it your pension fund, it is in your state's general fund. State's run their own money market funds, and have been buyers of the toxic paper.
  


• State money market funds do not have a parent bank to bail them out. They have only the taxpayer. It is the taxpayer's money that is in these money market funds. (Note: The federal government is restricted from this type of activity by the Treasury's tax and loan account program, which places federal taxes in commercial banks, but only in safe, liquid accounts. States are not following this model.)
  


• The bind on state budgets is a direct line into the middle and lower income levels, where recessions are made. Demand Side perspective gives state budgets a full pass-through in the multiplier. That means a hit to the state government is a body blow compared to a hit on the financial sector, which is a jab.
  

The problem is not a liquidity problem. A liquidity problem is where an instrument has a price, but there is no money to buy it. These "credit market innovations" are opaque, so potential buyers guess at what they're worth and then discount the value for the risk of not knowing. Potential sellers don't like the prices. No market. But not because of liquidity.

While everybody who owns this toxic paper is blowing smoke to disguise their irresponsibility, it is coming clear that many states are in significant jeopardy. A short look at one example will also show how big $400 billion is, or $900 billion, or even $1,500 billion -- all figures that have been offered as costs for this debacle -- and what sort of fix they're in.

Florida has an annual budget of $50 billion, according to Mason. Its annual revenues are about $36 billion. (Notice, a large state's annual budget is small compared to the impending problem.) Imagine that Florida has invested in structured debt with tax money in a kind of self-sponsored money market accout. Maybe 4.37% of this debt is in instruments already downgraded to near zero, and maybe another 7.33% is in portfolio credit watch negative. That could be $2.2 billion in the first account, and $3.6 billion in the second account. Maybe this is 12% of the fund.

Consider further that, as Florida, your sales tax revenues are plummeting from the recession and you have no income tax. This is 12% of your annual revenue for 2006. The outlook for 2007 is worse. You have no big brother to bail you out, as the bank's money market funds do, or as the entire financial sector does with the Fed. You have mandated programs like food stamps, health and social services, etc.

Remember that in the Depression, some state's went bankrupt, closed universities and other operations, and paid remaining employees with IOUs.

Be glad you are not Montana, with possibly 20% of its fund in jeopardy.

The economy? No. Fed action is to benefit the financial sector

If Fed action is supposed to forestall a downturn in the economy, there is a small problem. Interest rate cuts work into economic results only after a lag of about 18 months.

The Fed action is really about bailing out the financial sector. Banks are in big trouble, with their off-balance sheet vehicles threatening to come onto the balance sheet when more CDOs turn bad. The so-called Super Conduit, or whatever its current name is, will only push the problem out six months. When the borrow short, lend long SIVs come back home to live, the sheet will hit the fan.

At least $400 billion is likely tied up in this mess.

And to be fair, the Fed didn't pretend that this was an attempt to improve things on Main Street. Their statement began:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/2 percent.

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

(emphasis added)

There is panic in the big banks.

The problem is too big for the only tool the Fed ever uses, the interest rate, to solve. Rate cuts are no doubt the wish of everybody on the FOMC's cocktail circuit and these banks and bankers will call the tune for the Fed, but this is not a moral hazard we're driving a golf ball into. This moral hazard is a sinkhole swallowing the dollar.

AWOL - Where is the political angst when you need it?

Listening to the first part of the House Financial Services Committee hearing on predatory lending and financial sector packaging is tedious. The consensus is, "Let's get the money flowing like it was before, but protect the borrowers from getting fleeced."

The money will not flow in a healthy mortgage sector in the same amounts, because those amounts were based on too low interest rates and packaging of mortgages to sell in shady CDOs upstream. Lots of cheap money leads directly to this kind of bubble and bust, it is the leverage that makes that kind of volatility possible.

Inflating home prices made people feel good, and lets them think that they are financial geniuses and promotes spending and so on, but in the end saddles people with debt they don't want and undermines the security of their financial assets and breaks their nest eggs.

The current hearings notwithstanding, and recognizing Chairman Franks went so far as to clear his calendar, nobody I am aware of is pressing the culpable in the recent financial sector screw-up or reforming the troops around legitimate policies.

• Bombs are dropping on middle class America with housing prices crumbling. It is not only those losing their homes, but those who are losing equity who are hurt.


• The bombers are the ludicrous mortgage peddling schemes, but they were sent into the skies by the too low for too long interest rates set by the Fed.


• Traditional defense have been sabotaged by the same bogus financial actors who force-fed the mortgage peddlers. Bad loans were packaged and gilded with spray paint and sold upstream as gold bricks.


• Yes, home buyers should have known it was too good to be true. Buyers of packaged debts should have wondered why they were so light. But even if all the naive or purposefully apathetic are punished, many millions of others are innocent victims.


• Homeowners who were led out into the open by the Fed's low interest rates are being blamed for coming under fire. It's like blaming those in the twin towers for being at work in what they knew was a terrorist target.

The problem is that the generals are chicken hawks. The Fed knows nothing other than the big red interest rate button. The "Easy" button. The Supply Side strategy of the Bush administration never worked and never can work. The SEC has political hacks rather than marshals of the market.

Were the shoe on the other foot, and a Democrat in the White House, the traveling Republican bellows would be touring the talk shows fanning the flames of crisis into full-blown panic. Look what they did with 9-11.

On the other hand, the Democrats are revealing too much about themselves when they are not on top of this. This is not a passing problem. The housing sector has saved the economy during the past six years. Debt for households, debt for government, cheap money, falling dollar.

Interest rates can be low and stable if the credit worthy are the only people able to borrow and if margin requirements on every kind of financial exchange are raised. High.

Have the Democrats bought into market rhetoric? Do they believe the architects of this falling house of cards who seem to say the Market is still prescient, but that it needs to be calmed like an hysterical matron (Jim Cramer?).

To revisit stocks: Be sure, stocks are not up because of strength in their fundamentals or faith in the economy, but because the villas of SIVs and hedge funds got washed away and all that liquidity at the top has only stocks, commodities and currency hedges to run to.

There is no strength.

The dollar has been heading south for years, fleeing Supply Side II and Greenspan Cheap. Now, with Bernanke cutting rates, it's on the run. With it goes the Chinese yuan, being pegged by its government. Look for the rest of the world to try to quarantine the US and China.

Let's put it simply:

• The Fed under Greenspan held short-term rates under water so long, they expired as a tool of economic policy. (See inverted yield curve. The back end of the yield curve is not responding.)


• The Bush tax cuts and Fed bailouts and so-called financial innovation have liquidity sloshing around at the top. This is the excess in the financial system that is the source of instability.


• Bush economic chicken hawks have spared the financial sector from even the most minimal standards. The bad apples have gotten into the barrel. Even Wall Street's less intoxicated voices can be heard calling for hedge fund disclosure and conflict of interest protections. The Bush team is in the bunker and out of earshot.
  

Dear Democrats: It's the economy, stupid.