Saturday, April 24, 2010

How much financial reform do we need?

I begin this post with some trepidation. If you're really smart, I always say, you're never afraid to say "I don't know," and I certainly cannot claim to understand contemporary finance, derivatives, credit default swaps, and the rest of the new financial paraphernalia that have made multimillionaires out of Wall Street traders while bringing the world economy to it knees. Gradually certain critical facts seem to be emerging, and I am tentatively trying to put two and two together and hoping for a result that is reasonably close to four. I hope that any more knowledgeable readers will comment--we all need to know as much as can about what is happening in order to behave like informed citizens.

One doesn't hear much about Enron nowadays, but I am beginning to think that it was far more than just a brilliantly fraudulent new enterprise that came a cropper. Enron was, as I understand it, the pioneer in creating and selling energy derivatives, a form of futures contract that allowed large energy consumers to insure against swings in prices. They had many consequences. According to the excellent documentary, The Smartest Guys in the Room, Enron's instruments allowed it to drive the price of power in California through the roof in 2001, leading directly to the recall of Democrat Gray Davis and the election of Arnold Schwarznegger. Enron itself collapsed shortly thereafter and several of its executives were convicted of fraud. The Sarbanes-Oxley Act was also passed, requiring greater financial transparency, but nothing, apparently, was done to restrict or regulate trading in derivatives, which became a mainstay of the new big banks. In 2007-8, as we know know, those banks managed to bid the price of oil up to new heights--in part, presumably, by using derivatives. The price fell by nearly 100% but has now gained about half of that loss back. How much of this actually relates to supply and demand, we no longer know. I did see a report in the last two weeks--one I unfortunately failed to save--to the effect that US businesses are now forced to spend far more money on futures contracts for their energy supplies. That, to me, is an example of how our new financial institutions are become parasites on the more productive sectors of the economy that remain.

The government's suit against Goldman Sachs, which turns out to have cooperated with a hedge fund manager named Paulson (no relation to the Treasury Secretary) to bet against securities it had packaged and marketed itself, is another example of how bad things have gotten. I am intrigued that while the SEC has charged Goldman with fraud, they have not charged them with insider trading--perhaps because the insider trading laws do not apply to credit default swaps. Yet surely Goldman's actions were equivalent to those of a corporation shorting its own stock in anticipation of a bad earnings report? And surely the opportunity to float an unsound investment with the right hand, while shorting it with the left hand, is an opportunity too promising for anyone to miss? Credit default swaps are a form of insurance, but the resources of the megabanks are so enormous that they can, in effect, raise or lower the value of assets they have just chosen to insure, according to what will benefit them and their partners the most. This is even easier as long as the Federal Reserve continues allowing them to borrow at near-zero interest.

Brokers, traditionally--like bookies--are supposed to make money on every transaction while declining to gamble themselves. (The journalist Larry Merchant, author of a book on betting on football, described bookies as gamblers who had decided they would rather pay the rent.) But that tradition was destroyed by the repeal of Glass-Steagall, which allowed the big banks to trade on their own. I am beginning to think that we have turned the economy into a huge casino, one in which the house not only takes a percentage of every bet, as in the past, but also rigs the heaviest action. Other evidence is surfacing that major market players understand the game is rigged. I recently heard an interview with Harry Markopoulos, the whistle-blower who vainly warned the SEC for years that Bernie Madoff must be running a scam. He is convinced that Madoff's clients knew that he could not possibly be generating such returns within the rules and must be cheating somehow--they just didn't understand exactly how he was doing it.

The big banks have only existed in their current form for about a dozen years, and one would have to go back to the Third Reich, it seems to me, to find an institution that did so much damage in so short a time. Yet because they have not killed people, they are still standing and making nearly as much money as ever. These are the institutions which, I am convinced, we need to tame. Paul Krugman wrote tellingly yesterday that President Obama should not have said his reforms would be good for Wall Street: effective reform will indeed reduce the profits Wall Street earns, as well it should--and like Franklin Roosevelt, the President should not be afraid to say so.

All this has another, very sad dimension. Beginning in 2003, as many of you know, the late Bill Strauss and myself, together with about ten other classmates from the Harvard Class of 1969, began campaigning against the multi-million dollar bonuses paid to managers of the Harvard Endowment, which had become a hedge fund. We were not too surprised by the reaction of the financial press, which unanimously argued (as did President Lawrence Summers) that the managers had earned every penny, but we were certainly disappointed to find that many current Harvard undergraduates sided with them as well. I began to realize that our whole elite educational system had become a large funnel whose small aperture emptied annually into Wall Street. Twenty years ago, in my book Politics and War, I wrote that the cataclysm of the Napoleonic era occurred because war and diplomacy were the main spheres of activity of ambitious young men, and commented that the industrial revolution had come along just in time to provide them with a healthier outlet for society. Alas, the financial revolution has not done the same.

An army of lobbyists is now trying either to block financial reform completely (an endeavor in which the Republican Congressional leadership has joined) or to deprive it of any significant meaning. This week procedural votes in the Senate will begin and we shall find out whether the Republicans will once again unanimously follow their leaders. (Charles Grassley broke ranks in the Agriculture Committee, but without promising to vote for an eventual bill.) Yet in any case these new monsters will be very hard to slay. It took many decades to put a real dent in the power of the huge corporations that emerged from the Gilded Age, and it has taken about 30 years to undo the work of the New Deal and (in some respects) the Progressive Era. If President Obama manages to reverse the trend, he will have done well.


Paul Hillman said...

This comment says much

". . . our new financial institutions are become parasites on the more productive sectors of the economy that remain."

I think this is so true

Anonymous said...

"I am beginning to think that we have turned the economy into a huge casino, one in which the house not only takes a percentage of every bet, as in the past, but also rigs the heaviest action."

No need to begin to think this. It's true!

The test run was the savings and loan disaster. The same sort of behavior (gambling on the lack of regulatory personnel to oversee the process), savings and loan presidents, mortgage brokers, appraisers, surveryors, and title companies worked together to artificially drive the prices of houses up in the '70s and early '80s.

Because the prices were going up and a lot of people were making a lot of money selling their old house, everyone turned a blind eye and embraced the first repeal of a 1930s reform law.

In one instance of S&L fraud I will always remember because it was so outrageous, these people were able to get a VA guaranteed loan for $60,000 on a house which was actually a GARAGE on half a lot. Whether the veteran who signed the loan papers was in collusion or not, we never found out, but the value of the property was probably no more than $3000. The savings and loan paid off the others involved with the $57,000 in profit on the deal, pocketed the extra money, and then after the appropriate number of months, the mortgage was in default and then paid off by the government. The S&L and other conspirators got a tidy $107,000 on that deal. And in the '70s, that was still a good bit of money. Multiply that by all the hundreds of thousands of new home sales in the '70s and you have the reason all the S&L presidents were suddenly buying mansions on the lake!

Not ONLY did the government pay off the loan, but they footed the bill for the taxes on a house supposedly worth $60,000 for six years while the '80s recession raged!

The S&L collapse came when all those people with runaway AMRs could no longer sell their upside down mortgages and move on to another.

Like I say, it was all a test run for what when down after Glass-Steagall got repealed.

In the intervening years, the high rollers figured out what went wrong (or so they thought) with the S&L plan, and proceeded to run the exact same scam, only this time, they were able to co-opt the entire financial system (thanks to the repeal of Glasss-Steagall). Even worse, they co-opted the ratings services and the Fed.

The government, all focused on one thing (fairness in lending and a happy electorate), became a willing and completely naive partner to it all as well. Everybody was making money. We were ALL making money. Nobody wanted to rock that boat. Not after the misery of the '80s. And conservatives are correct when they say that the "pressure to lend to unqualified minority buyers" was there. But that was the EXCUSE. They were going to make money on every house sold period. The PRESSURE was on the low end loan officers who didn't understand the game but knew that their own continued employment depending upon their selling to ALL buyers, not just the qualified ones!

So when Glass-Steagall came up for repeal, the warnings were ignored. Everyone forgot about the '80s, forgot about the dangers of an Adjustable Rate Mortgage, forgot about the rule that you never, ever borrow a down payment, forgot about keeping your house payment at under 25% of your net income, forgot about loan qualifications at all. Homes that were worth $40,000 at the end of the '70s were valued at $80,000 by the mid-'80s in the first run. Now homes worth $80,000 when that bubble collapsed became valued at$180,000.

Yet there is NOT ANY GREATER VALUE in the these homes, no improvements, no bettering of the neighborhood, nothing. None of these people have been able to afford to maintain these overpriced homes, so they are falling apart, and yet the value keeps going up and up and up. SOMETHING has been driving it...the very casino gamblin scheme you "being to think" we're experiencing.

Anonymous said...

"Yet surely Goldman's actions were equivalent to those of a corporation shorting its own stock in anticipation of a bad earnings report?"

Corporations and corporate managers routinely do that, not by shorting but by issuing new stocks and selling them to dumb public. You will find that new issuance usually peaks around market top.

Steve Clark said...

How much Reform?
1. Reinstate Glass-Steagall and force “investment banking,” otherwise known as the speculative impulse, back into the private sphere of rich gamblers where they can’t leach off the savings of other people.
2. Channel less of the expansion of the money supply through commercial banks and, instead, channel it more directly into targeted government stimulus financed by substantial, additional government borrowing (up to about 200% of GNP – as was typical in the 1930s and 40s).
3. Collaborate with other national governments, central banks and civil society organizations to institute a financial system-wide transaction fee on all electronic commerce to (a) curb speculation, (b) allow oversight of aggregate spending, investment and financial trends (early bubble detection) and, most fundamentally, (c) finance a qualitative leap in global-local/private-public collaborations in social and economic problem-solving, which is critical to human survival in the epoch ahead.

Aunt Katie said...


I don't want to monopolize this space, but will just amend Paul H's perceptive remark, after 'on', with '...what little remains of the...'

Then, Question: What really is the point of financial reform, given that larger reality?

The financial 'sector' itself, properly conceived as a 'sector' 'within' a nation state economy, is ancillary to something else, which we no longer have.....

These things are all obviously best left to the tender mercies and intricate ways of market forces.

all the best,
Gerald Meaders

Gerald said...

I read a book, a long time ago, which I would recommend to anyone, re 'financial reform'.

I haven't yet read his new book, on similar recent subjects, but am in line at library.

Read Liar's Poker.

all the best

Anonymous said...

E-mail suggests Goldman knew Harvard would lose

You didn't want Meyer because he was making too much money. I am
so glad Summers did much better
for you.

Priceless !!!!!!!!!

Now you got two chicks in charge
- which way do you think the
endowment will go?

Anonymous said...

Bill Clinton: Timing Of Goldman Sachs Suit Is "Suspect"

Is any commentary necessary at all?

Anonymous said...

Bill Clinton ‘not at all sure’
Goldman broke law, but questions
‘underlying merit’ of derivatives

Isn't Clinton YALE educated attorney?

Anonymous said...

Dr. Kaiser:

thought you might find this article

Is Harvard Just a Tax-Free Hedge Fund?

Anonymous said...

Dr. Kaiser:

you might find the article informative.

The ACLU Approves Limits on Speech

Aunt Katie said...

Great editorial

Some of the implications of the post, re surveillance, and other things, really are staggering, given the overly open society and higher educational system we have long run, not to mention the global workforce Americans thought they must have, even domestically; and the fact that internet sites now give much higher knowledge away now for free anyway(MIT; Wikipedia; etc.).

Twenty years ago or so, many English language schools ran programs for all kinds of people wanting to experience American culture and learn English at the same time. My mother had a homestay for such people, including many Saudis and others from all over the world. She had a wonderful time. So did they. But now, in retrospect, has economic, or financial, globalization(modernization) been such a smart idea?

All the best