Thursday, May 06, 2010
THE GOLDMAN SACHS CASE Part III: "Jokers to My Right" James S. Henry
Well, la gente Americano may not know the difference between a synthetic CDO and a snow shovel, but the masses are clearly frothing for a taste of banquero al la brasa, fresh from the spit.
"Financial reform," whatever that means, is now far more popular than "health care reform." And it has only recently become even more so, in the wake of all the recent investigations and prosecutions -- Warren Buffett might say "persecutions" -- of the "demon bank" Goldman Sachs.
Evidently the masses' appetite for banker blood was only slightly sated by the SEC's April 16th civil charges against Goldman, Senator Levin's 11-hour show-trial of senior Goldman officials on April 27, and the "entirely coincidental" announcement on April 30th that the US Justice Department -- which is under strong political pressure to bring more fraud cases to trial, but also tends to screw them up -- has launched a criminal investigation into Goldman's mortgage trading.
In the wake of this populist uprising, Senate Republicans have suddenly adopted "financial reform" as their cause too, allowing the Senate to commence debate this week on Senator Dodd's 1600-page reform bill.
However, this promises to be a lengthy process. While reform proponents like US PIRG and Americans for Financial Reform were hoping for final action as early as this week, Senator Reid now expects to have a Senate bill by Memorial Day at the earliest, and Obama only expects to be able to sign a bill by September.
That's just two months ahead of the fall 2010 elections, so there's not much room for error. But the beleaguered Democrats may just be figuring that they'd rather bash banks than run on their rather mixed track record on health care reform, unemployment, climate change, and offshore drilling, let alone -- Wodin forbid -- immigration reform.
In any case, Senator Dodd's bill has now been through more permutations than a Greek budget forecast. The latest one discards the $50 billion bank restructuring fund as well as new reporting requirements that would helped to spot abusive lending practices.
These concessions apparently were part of retiring Senator Chris Dodd's Grail-like
quest for that elusive 60th (Republican) vote -- rumored to be hidden away and guarded by an ancient secret order known as "Maine Republicans."
A GOAT RODEO
Meanwhile, behind the scenes, leading Republicans, aided by several Democrats from big-bank states like New York, California, and Illinois, and countless lobbyists, have been trying to weaken other key provisions in the bill, which was already pretty tame to begin with.
The most important measures at issue pertain to derivatives and proprietary trading, the power of the new Consumer Financial Products Bureau (especially, according to Senator Shelby, the Federal Reserve's shameless power grab over orthodontists), the regulation of large "non-banks," and (interestingly, from a states' rights perspective) the power of states to preempt federal regulation.
On the other hand, the bill has also inspired dozens of amendments from a cross-section of Senators who appear to be genuinely concerned -- even apart from the opportunities for grandstanding -- that the Dodd bill isn't nearly hard-hitting enough.
Some of these amendments are purely populist anger-management devices that don't really have much to do with preventing future financial crises.
These include Senator Sanders' proposals to revive usury laws and audit the Federal Reserve, a proposal by Senators Barbara Boxer and Jim Webb for a one-time surtax on bank bonuses, Senator Mark Udall's proposal for free credit reports, and Senator Tom Harkin's proposal to cap ATM fees.
The very first amendment adopted was also in this performative utterance category: Senator Barbara Boxer's bold declaration that "no taxpayer funds shall be used" to prevent the liquidation of any financial company in "receivership."
Cynics were quick to point out that in any real banking crisis, this kind of broad promise would be unenforceable, since it would also be among the very first measures to be repealed.
Other proposed amendments sound like more serious attempts at structural reform.
These include the Brown-Kaufman amendment that tries to limit the number of "too big to fail" institutions by placing upper limits on the share of system-wide insured deposits and other liabilities held by any one bank holding company, and the Merkley-Levin amendment, which attempts to "ban" proprietary trading and hedge fund investments by US banks, and also defines tougher fiduciary standards for market-makers.
But so far neither of these measures has received the imprimatur of the Senate Banking Committee, let alone Senator Reid. This means that for all practical purposes they are may amount to escape valves for venting popular steam, but little more.
This is especially true, given the delayed schedule that Reid, Dodd, and the Obama Administration seem to have accepted, which will relieve the pressure for such reforms.
Furthermore, upon closer inspection, both proposals leave much to be desired. Indeed, one gets the distinct impression that they dreamed up by Hill staffers on the midnight shift to appease the latest cause célèbre,
For example, the Brown-Kaufman amendment, highly touted by chic liberal "banking experts" like Simon Johnson, doesn't mandate the seizure and breakup of any particular large-scale financial institutions directly. Nor does empower the FTC to set tougher standards for competition in this industry, as it might have done, or even specify what kind of industry structure would be desirable from the standpoint of avoiding banking crises.
To a large extent that simply reflects the paucity of knowledge about the relationship between structure and behavior in financial services. As a bootstrap, the amendment specifies arbitrary caps on bank activities that may or may not be related to actual misbehavior -- for example, the share of "insured deposits" managed by any one bank holding company (≤ 10%), and the ratio of "non-deposit liabilities to US GDP" (≤ 2%).
This has arbitrary consequences. Under the limits in the amendment, for example, Wells Fargo and Citigroup, the # 4 and #1 banks in the country by asset size, would nearly avoid any breakup, while JPMorgan and BankAmerica would feel much more pressure.
Meanwhile, evil Goldman Sachs' minimal .3% shares under both limits would leave it plenty of room to grow -- perhaps even by acquiring the extra share that the "Big Four" would have to spin off.
Furthermore, even the largest US institutions might be able to avoid the caps by devoting more attention to large-scale private banking customers, whose deposits and other investments would avoid these regulations, or by conducting more of their risky business through offshore banking centers.
Indeed, this also suggests a key problem with the Merkley-Levin amendment as well: it is a US solo act. It completely ignores the fact that even our largest banks, and the US financial system as a whole, are part of a competitive global financial market.
As this week's Greco-European financial crisis has underscored, to be effective, bank regulation and structural reform must be conducted on a coordinated international basis. Unilateral initiatives only drive bad behavior to the myriad of under-regulated offshore and onshore financial centers.
From this perspective, I'm surprised that Senator Levin, a long-time critic of offshore financial centers, has proceed in such a ham-handed way with this. This was his year to finally round up global support to crack down on offshore centers -- a precondition for effective global bank regulation. Instead he decided to target Goldman and pursue this wayward, sloppy attempt at unilateral reform -- as if the Isle of Man, Guernsey, Jersey, Bermuda, and the Cayman Islands, let alone London and Zurich and Singapore and Hong Kong, are not waiting in the wings.
WHAT HAVE WE LEARNED?
CONSOLIDATION (UNDER BOTH PARTIES)
First, as shown in the above chart, the US banking industry has indeed undergone a major structural transformation, especially December 1992. The following 15 years became the era of Wild West banking, when all the lessons that should have been learned from the Third World debt crisis were forgotten. It became an era of rampant deregulation, rising US public and private debt levels, and asset speculation.
The impacts on financial structure were far reaching and rapid. Back in December 1992, there were more than 13,500 banks, and the top four US banks accounted for less than 10 percent of the sector's jobs.
Already by 1998, there was a decided increase in this concentration level, to more than 20 percent. Today there are fewer than 8000 banks. The top 4 alone -- Citigroup, JPMorganChase, Bank of America, and Wells Fargo -- now employ more than 800,000 people, over 40 percent of the US total. Indeed, together with the failed banks they acquired, the top four banks have accounted for almost all the sector's employment growth; the rest of the sector has shrunk.
Tiny Goldman has also been growing, but it now only accounts for about 18,900, less than 10 percent of any one of the top four.
This growing concentration is also reflected in most key US banking markets, especially the markets for deposits, overall bank loans, real estate loans in general, home mortgages, and credit derivatives. As indicated, in each of these markets, the market share commanded by top four banks has increased from less than 10 percent in 1992 to 40-50 percent or more by 2010. In the case of the credit derivatives market, the share now approaches 90 percent.
Nor has this increasing concentration been accounted for by superior performance. Indeed, the "big four" also now account for more than 78 percent of all bad home mortgages -- behind in payments, or suspended entirely. While some of that is accounted for by the acquisition of failing institutions, most of it is not.
THE ECONOMICS OF GOLDMAN BASHING
Third, once again, for the sake of Goldman bashers in the audience, as indicated above, its share of each of these key market indicators is trivial. Even in credit derivatives, the segment for which Goldman has taken such a beating, its market share today is just 8 percent, compared to the "Big Four's" commanding 88 percent. And Goldman's share of real estate loans, home loans, insured and uninsured bank deposits, and bad home mortgages are even lower.
Just to pick one example: today the "top 4" banks have more than $204 billion of bad home loans, compared with Goldman's $0.0 of such loans.
From this standpoint, the Levin hearings were a stellar example of completely ignoring industry economics. They singled out a smaller, more successful, widely-envied target for political scapegoating, while ignoring the much more economically much more important financial giants.
THE MORTGAGE-INDUSTRIAL COMPLEX
The key driver on the domestic side of all these developments is a political-economy complex that in the long run has had perhaps as profound an influence on our nation's political and economic system as the legendary "military industrial" complex. This is what we've called (in the first chart above) the "US mortgage-industrial complex," including financial institutions, real estate firms, and insurance companies. From 1992 to 2010, in comparable $2010, this industry spent an average of $2793 per day per US Senator and Congressman on federal campaign contributions and lobbying -- far more than the corresponding levels in the 1970s and 1980s.
Except for the insurance industry -- where health care reform efforts by Clinton and Obama tilted the giving -- Democrats and Republicans have more or less divided this kitty pretty evenly. It is also important to note that more than 71 percent of total federal spending by these industries from 1990 to 2010 was on lobbyists, not campaign contributions. While cases like the recent Citizens United decision may affect this balance,
Furthermore, within the financial services industry, the top four US banks alone have accounted for at least 20 percent of all spending on federal lobbying and campaign contributions (in comparable $2010) from 1992 to 2010. Investment banks as a group -- including Goldman, Lehman Brothers, Bear Stearns, Morgan Stanley, UBS, Credit Suisse, and their key predecessors, especially Paine Webber and Dean Witter -- added another 8 percent. But once again, by comparison, and contrary to its reputation as the premier political operator in Washington, Goldman Sach's share of total "real" spending on lobbying and contributions was relatively small -- just 2.2 percent.
This was just 40 percent of what Citigroup spent, and less than 60 percent of what JPMorganChase spent during this same period.
C'mon guys -- Is it any really wonder that Jamie Dimon gets invited to the Obama White House for dinner while Lloyd Blankfein gets served for dinner on a spit up on the Hill?
Ironically, if it were just a question of a given institution's loyalty to the Democratic Party, Goldman -- and indeed Lehman Brothers and Bear Stearns as well -- would have clearly had the inside edge. As shown below, these investment firms clearly preferred Democrats over the long haul.
Ironically, to paraphrase Senator Levin, especially in Goldman's case the Democratic Party appears at least so far to have "put its own interests and profits" first, basically turning a blind eye -- at least so far -- to the substantially much larger potential misbehavior of the "big four."
Meanwhile, when President Obama traveled to New York two weeks ago to give a speech on the urgent need for financial reform, the peripatetic Mr. Dimon could be found in Chicago. He was rumored to have met with CME and/or Board of Trade executives to prepare to invest in an exciting new "derivatives exchange," should JPMorgan need to transfer its substantial share of that business -- several times Goldman's market share, even in credit derivatives -- to an open exchange.
JOKERS TO MY RIGHT
So all this concentration of political and economic power in US financial markets would appear to make a strong prima facie case for a serious structural reform, perhaps even along the lines of the Brown-Kaufman amendment, n'est pas? Unfortunately, no.
As we argued earlier, that amendment sets very crude targets that bear little immediate relationship to bank misbehavior or even political influence. At worst, the caps might just force bad behavior like risky derivatives and hedge fund investing offshore. And the bill's current caps would, at best, just force banks like Cit, JPM, and BankAmerica to shed less than 10 percent of their market shares, setting them back to -- say -- 2005 levels.
In other words, they're not a substitute for effective regulation. But that puts us back in the chicken-egg problem with "regulatory capture."
My own particular solution to these dilemmas is suggested by the following chart -- although it also suggests
that the most opportune time to implement it has already come and gone. In terms of the current banal American political discourse, it would be probably be quickly dismissed as 'socialist," although that term is such a catch-all that it has really become virtually useless, except as a device for red-baiting timid liberals.
THE CHILEAN MODEL
So don't take my word for it; let's ask the ghost of Chile's General Pinochet, whom I'm quite certain no one ever accused of being a "socialist," at least not to his face. For years he was best known among economists as one of the key political proponents of Milton Friedman's so-called "Chicago School" of ultra-free market economics. But in February 1983, during a severe crisis when all the banks in Chile failed, Pinochet showed that he could be quite pragmatic -- with a little arm-twisting from from leading US banks, which threatened to cut off his trade lines if he didn't nationalize the banks' debts.
So, after swearing up and down that private debts and private banks would never be nationalized, Pinochet's government did so. Three to six years later, after restructuring the banks and cleaning them up, and privatizing their substantial investments in other companies, they were sold back to the Chilean people and the private sector -- for a nice profit. (Similar policies were also followed by "socialist" Sweden in the case of a 1990s banking crisis, but the Pinochet example provides a more instructive example for so-called conservatives. Much earlier, General Douglas MacArthur, a lifelong Republican, also employed similar pragmatic tactics in restructuring Japanese banks in the early 1950s.)
Now this is the plan that the US Treasury (under Paulson and then Geithner) might have adopted in the Fall 2008 - Spring 2010, if only it had not been so hide-bound -- and in the case of the Obama Administration, so wary of being termed a "socialist."
In hindsight, the economics of such a pragmatic temporary government takeover and reprivatization would have been compelling. At its market low in March 2009, the combined "market cap" of the "big four" banks was just $120 billion -- including $5 billion for Citi and $15 billion for Bank of American. This was a mere fraction of the capital and loans that were ultimately provided to them. (At that point Goldman's market cap had fallen to $37 billion from $80 billion a year earlier -- not as steep a decline as the giants, but clearly no picnic for its shareholders, either.)
Only a year later, while the "demon bank" Goldman has recovered to more or less where it was in June 2008, before the crisis, the market cap of the "top four" US banks is now nearly six times higher than its low in March 2009, and, indeed, at an all time high -- well above both previous peaks.
Too bad the US taxpayers have only captured a small fraction of that $500 billion industry gain.
Too bad the US Treasury hasn't exercized strong "socialist" control over these institutions, changing the way they behavior directly, and restructuring them in the interests of the economy as a whole before selling them back to the private sector.
Too bad that "big four" lobbyists are now back in force on the ground in Washington DC, influencing the fine print of the "financial reform" bill in ways that we will probably only understand years hence. Despite its woes, undoubtedly this will be a bumper year for political spending by the financial services industry.
Of course, President Obama IS now being widely demonized as a "socialist" -- anyway.
(c)JSH, SubmergingMarkets, 2010
Tuesday, April 27, 2010
THE GOLDMAN SACHS CASE Part II: "The Crucible" James S. Henry
Whatever the ultimate legal merits of the SEC's case against Goldman Sachs -- and those appear to me to be questionable at best --
its most important contributions are being made right now. They are not judicial, but political.
(1) If anyone needs the benefit of the new "financial literacy" program proposed by S.3217, Senator Dodd's proposed financial reform bill, it is the US Senate. Many members of the Senate -- and by extension, the House -- don't seem to understand very basic things about the structure and role of private capital markets, finance, and business economics, let alone global competition. In the world's largest capitalist economy, this level of ignorance on behalf of our political elite is really mind-boggling.
(2) After 18 months of intensive investigation, the US Senate's Permanent Subcommittee on Investigations and the SEC have not so far been able to find anything that is clearly illegal to pin on Goldman Sachs.
(3) On the other hand, on the secondary trading side of Goldman's business, Goldman traders clearly have "market maker" ethics, not investment adviser ethics. They've grown accustomed simply to providing market liquidity for whatever securities clients happen to want -- or can be persuaded to want, even if Goldman is taking opposite positions at the very same time in the very same securities.
For example, regardless of what Goldman's own sales people felt about the terrible quality of the synthetic CDOs they were selling in 2007 -- including many securities packaged out of "stated income" mortgages -- they continued to sell anything for which there was a current price.
Goldman's trader culture simply doesn't buy the notion that market
makers have any "duty to serve the best interests of their clients. In competitive world, this amoral culture may well be essential to being a successful "market maker," and Goldman is one of the most successful secondary traders in the world However, if we expect some higher standard of behavior toward clients, this is likely to require new rules; Goldman will never get there on its own.
Of course, in a highly competitive global market, any such rnew ules might just cause this entire business to move offshore, to London, Hong Kong, Singapore, or any number of other offshore financial centers.
(4) With great respect to Michael Lewis, the notion that Goldman Sachs engaged in a hugely profitable "big short" in 2007-2008, in the sense of secretly betting systematically against the same securities that it was underwriting for its clients, is easily overstated. Goldman's investment portfolio in mortgage securities turned negative in early 2007, was net short all year long in 2007, and at times had up to $13 billion of gross shorts, the bank's net profits from all this shorting that year was $500 mllion to $1 billion. The following year, 2008, its mortgage portfolio lost $1.8 billion
(5) There appears to be enormous pent-up rage and ressentiment in the country at large, right now, driven by the financial crisis, the slow recovery, high unemployment, and the loss of homes and pensions, on the one hand, and the widespread perception that banks not only created the crisis, but have also profited immensely from it. Most people may not know a CDO from a dustpan, but there is a very disturbing tendency to seek scapegoats, dividing the world into villains and victims. Ironically, the most obvious targets include companies like Goldman Sachs, one of our most successful, better-managed, if trader-ridden companies.
(7) On the other hand, these other major private banks, plus Lehman Brothers and Bear Stearns, were by far the largest players in the private mortgage market. If they had followed Goldman's risk management, accounting, disclosure, and leverage practices, the worst of this crisis might well have been avoided. Indeed, it appears that one reason these generally much larger firms did not adopt such practices was because -- unlike Goldman -- they genuinely believed they were "too big to fail."
(8) Going forward, the real problem with Goldman market was not, by and large, illegal behavior, but an excess of perfectly legal behavior that may well be socially unproductive and way under-regulated. Especially in a world where other countries have fallen behind in the move to update their financial regulations, dealing with this problem will require much more than lawsuits and investigative hearings.
IN THE DARK TRUNKS...
Today's hearings probably came as close to fireworks as investment banking and "structured finance" ever gets. In one corner there was Goldman Sach's slightly shaken, but still-unbent CEO Lloyd C. Blankfein (Harvard '75/ HLS '78).
There was also Blankfein's articulate, amiable life-time Goldman employee David Viniar (HBS '80); the now-notorious, side-lined 31-year old Goldman VP Fabrice P. (aka "fabulous Fab") Tourre (Stanford M.S. '01), architect of the particular "synthetic CDO" at the heart of the SEC case; and several other past and present stars from the "devil bank's" specialists in mortgage banking.
Ring-side support for the Goldman front line was provided by a hand-picked team of very high-priced trainer/coaches. This included former Democratic House Speaker Richard Gephardt, former Reagan Chief of Staff Ken Duberstein, and Janice O'Connell (aka "Puerta Giratoria"), a former key aid to Senator Dodd.
Senator Dodd, the retiring Chair of the Senate Banking Committee, has been working since November on S.3217, an epic 1600-page bill that Senate Republicans (with perhaps a little help from Fed staffers who opposed the bill) have just prevented from coming to a vote.
Of course Goldman has also hired Obama's own former chief counsel Gregory Craig as a key member of its defense team.
Once taken seriously as a "liberal" Democratic Presidential candidate, Gephardt has gone the way of all flesh, and is now completely preoccupied with serving such worthy clients as Peabody Energy, the world's largest private coal company; NAPEO, an association of "professional employer organizations" that is trying to dis-intermediate what little remains of labor rights for outsourced workers; UnitedHealthCare, a stalwart opponent of the "public option" in health care reform; and of course, Goldman Sachs, which has also employed the prosaic Missourian to pitch the (really insidious) idea of "infrastructure privatization" all over the country to cash-strapped state and local governments.IN THE WHITE TRUNKS..
In the other corner is the aging heavyweight champion from Michigan. Senator Levin (Harvard Law '59), is a low-key but tenacious warrior, with a mean-right hook; Goldman would do well not to underestimate him. He's a veteran critic, investigator, and opponent of global financial chicanery, dirty banks, and tax havens -- except perhaps when it comes to GM's captive leasing shells and re-insurance companies in the Cayman Islands and Bermuda (Heh, even a Dem's gotta eat!)
Sen. Levin is backed up by several knowledgeable, tough cross-examiners, especially Democratic Sen. Kaufman of Delaware and Republican Senator Collins of Maine. On the other hand, Republican Senators McCain and Sen Tom Coburn were a bit more "understanding" of Goldman's basic amoral attitude toward market-making.
In handicapping this contest, some observers predicted that the best and brightest from our nation's leading investment bank would basically roll over the "old folks" from the Senate.
In the first few hours, however, it quickly became clear that the bankers were a little under-prepared for the Senators' often-times impatient, hard-nosed tone, especially from former Prosecutor Levin, Collins, and Kaufman.
Nor were they prepared for the widespread, if perhaps naive and even "Midwestern" view that there was just something fundamentally wrong with the lines Goldman drew between pure "market-making" and providing investment advice.
For example, Sen. Levin was a real rat terrier on the question of whether it was ethical for Goldman market-makers in 2007 to be aggressively pushing clients like Bear Stearns to buy a CDO security called "Timberwolf" that Goldman's own internal analysts had called "shitty." Meanwhile, Goldman's ABS group was shorting Bear by buying puts. The panel of five present or former Goldman executives had trouble recognizing that there was any problem at all -- given the fact that, from a legal standpoint, Goldman had fully informed these clients about the risks they were taking.
For another $2 billion "Hudson" CDO deal that Goldman sold from its inventory, the firm's own sales people characterized the product as "junk," and indicated that more sophisticated customers might not buy it. Yet, according to Senator Levin, Goldman's selling documents for a portion of the sale characterized the deal as one where Goldman's interests and the client's interests were "aligned" because Goldman retained an equity interest in the Hudson package. In Senator Levin's view, this "retention" was misleading, simply because Goldman took time to sell down its position.
On the question of the Abacus transaction at the core of the SEC law suit, Sen. Levin was able to establish that the Goldman's Tourre never told the German bank that invested in the deal that John Paulson, the hedge fund manager who helped choose the portfolio, although he claimed to have told portfolio selection manager ACA. Oddly enough, from what we heard about other "raw deals" today for the first time, this now appears to have been perhaps the weakest deal for SEC to attack.
Similarly, Senator Collins pressed a group of Goldman securities "market-makers" very hard about whether or not they felt they had a "duty" to work in the "best interests of their clients." The responses she received indicated that these Goldman executives, while insisting on the organization's high ethical standards, also simply "did not get" the point that there might be some higher ethical, let alone legal, duties to clients, for pure market makers, beyond just providing them with legally-required disclosure.
Senator Levin claimed that these hearings have been in the works for more than a year. He says that it is just sheer coincidence that they are occurring soon after the SEC decided to file its case by a narrow 3-2 party lines vote, and right when Senator Dodd's reform bill just happens to be on the verge of being introduced.
Other sources indicate that Levin's investigation had been scheduled to continue through May, and that it was abruptly rescheduled after the SEC vote.
Furthermore, for someone who is supposedly holding hearings to gather facts and find out what was really went on, Senator Levin had already formed quite a few strong opinions prior to hearing from any witnesses -- as shown in his latest press release.
But so what? Even if he's was a little simplistic, filled with anti-bank animus, and eager to portray the financial crisis as a kind of morality play, and even if there's no big payoff other than the theatrics, it was definitely kind of fun to watch the "show trial" -- finally see someone asking big bankers tough questions under oath. After all, regardless of what "caused" the financial crisis and its interminable aftermath, it is pretty clear who is paying for it -- and it is certainly was neither these Senators nor the bankers in the dock.
( Stay tuned for Part III, which takes a closer look the Goldman Sachs case in light of these hearings, and consider the broader question of other "big bank" roles in the crisis.)
(c) JSHenry, SubmergingMarkets (2010)
Thursday, April 22, 2010
THE GOLDMAN SACHS CASE Part I: "Clowns to the Left of Me" James S. Henry
Well, we no longer have to worry only about corrupt bankers in Kyrgystan. Ever since the Goldman Sachs case erupted last week, there's been plenty of fresh banker blood in the water right here at home, with scores of financial pundits, professors-cum-prosecutors, and political piranha swirling around the wounded giants in the banking industry as if they were a herd of cattle crossing a tributary on the upper Rio Negro.
This feeding frenzy was precipitated by last Friday's surprising SEC announcement of civil fraud charges against Goldman Sachs -- heretofore by far the most profitable, highly-respected, and, indeed, public-spirited US investment bank.
Despite -- or more likely because of -- Goldman Sach's relatively clean track record and illustrious credentials, many commentators have assumed a certain Madame Defarge pose, reigning down censure and derision from the penultimate rungs of
their mobile moral pedestals.
Over the weekend, for example, Huffington featured a
half dozen vituperative columns on the subject, including a Vanity Fair contributing editor's feverish claim that the whole affair was somehow
deeply connected to one high-level
Wall Street marriage, and
host's denunciation of Goldman for refusing to appear on his show --
his show ! There was also a plea from Madame Ariana for criminal
In fact, this is a case where, as we'll see in Part III, the SEC's civil charges against Goldman Sachs are not only highly debatable, but largely beside the point.
Meanwhile, Bob Kuttner, another Huffy perennial, and one of our most prolific popularizers of conventional liberal dogma, asserted that Goldman demonstrates conclusively that Wall Street en tout is nothing but an on-going criminal enterprise, up to its eyeballs in outright fraud.
In a lurch toward financial Ludditism, Bob figuratively placed his hands on his hips, stomped his feet, and demanded nothing less than a "radical simplification of the
financial system" -- leaving it to the reader's imagination to determine just what the hell that means.
Will we still be permitted to use ATMs, checking accounts and paper currency, or will we all soon have to return to wampum beads and n-party barter?
Elsewhere, the Daily Beast published a de facto job application from Harvard Law's Prof. Alan Dershowitz -- otherwise well known in the legal profession as "He whose key clients are either fabulously wealthy or innocent."
Prof. Dershowitz argues -- quite rightly -- that Goldman' behavior, while no doubt
morally reprehensible, was also by no means clearly illegal. On the other hand, he also says the law is so vague that hedge fund investor Paulson might even be charged with conspiracy to commit fraud.
Well, ok -- except for the article's faint suggestion that for a modest fee, our country's finest criminal lawyer may just be available to help explain all this to a judge -- and also to argue that "only a tiny fraction of investment bankers who abuse their clients actually commit murder."
Finally, there is the omni-present, virtually unavoidable Simon Johnson, a Peterson Institute Fellow, MIT B-school prof, book author, "public intellectual," and "contributing business editor" at Huffington.
This week has been Prof. Johnson's heure de gloire, and he is living it to the fullest.
All week long he could be found at all hours on nearly every cable news channel and web site, pitching his own increasingly Puritanical, if not neo-Manichean views of the banking crisis and Goldman's role in it.
At first, Prof. Johnson merely expressed
delight that the US had finally reached its "Pecora moment" --
referring to the 1933-34 US
Senate investigation of Wall Street that, indeed, makes the modest
$8 million Angelides
like a California '68 love-in.
But by mid-week he'd had moved on to a much harsher assessment.
Not only is Goldman guilty as sin, but hedge fund investor John Paulson, one of the key parties to the Goldman transaction, deserves to be "banned for life" from the securities industry. If necessary, Johnson says, the US Congress should even pass an ex post facto bill of attainder!
He may therefore not be aware that the US Constitution (Article 1, Section 9) has explicitly prohibited both ex post facto laws and bills of attainder (legislative decrees that punish a single individual or group without trial) ever since 1788.
Just this month, a US federal district court in New York struck down Congressional sanctions that singled out ACORN, the community organizing group on precisely these grounds. The case is now on appeal.
Indeed, even in the UK, there have been no bills of attainder since 1798.
Despite Prof. Johnson's limited grasp of US or even UK law, and his Draconian appetites, I've actually grown rather fond of him lately -- or at least more understanding.
This is partly because since he left
the IMF in September 2008, he's apparently had a kind of road-to-Damacus epiphany.
He now realizes, as if for the first time, the enormous carnage that has been inflicted by a comparative handful of giant global banks, as well as the huge potential rewards of decrying these outrages from the roof tops.
But that 1+ year was more than enough time for him to leave a lasting impression at the IMF.
He is still fondly remembered at the IMF not
only for having entirely
missed the 2007-08 mortgage crisis even as it was unfolding, but also for deciding in
July 2008, less than 3 months before the entire global financial system nearly collapsed, to sharply increase
the IMF's growth forecast for both 2008 and 2009.
That was just one month before the otherwise-feckless Bush SEC initiated the 18-month investigation of Goldman Sachs that ultimately led to last week's charges.
If and when the Goldman Sachs case ever comes to trial, therefore, it may be interesting for Goldman's attorneys -- perhaps Prof. Dershowitz -- to consider calling Prof. Johnson as a witness for the defense.
After all, he probably qualifies as an expert on the heart-rending experience of just how difficult it was even for highly-trained experts to have clear peripheral vision, much less perfect foresight, back in the heady days of the real estate boom.
In Prof. Johnson's case, these included IMF senior management, executive directors, and a myriad of country officials who were all pressuring the IMF to inflate its forecasts back in 2008, just as housing markets and financial markets were beginning to crumble.
In July 2008, on Prof. Johnson's watch, they temporarily prevailed.
From this angle, the IMF Chief Economist's role might even be compared to that of a certain young Goldman Sachs VP.
Even in the dark days ahead, therefore, Goldman Sachs execs have at least a few consolations.
First, they can remind themselves that there were very damn few heroes in this sordid tale -- journalists, politicians, public intellectuals, and economists included.
Indeed, Brooklyn-born investor John Paulson may turn out to have been, if not quite a "hero," at least one of the few relatively straightforward and consistent players in the lot.
At least in his own investing, he consistently opposed the systematic distortions about the housing miracle and the exaggerate forecasts -- dare one say frauds? -- that institutions the US Treasury, the Federal Reserve, and Prof. Johnson's own IMF employed in the final stage of the real estate bubble, in a failed attempt to achieve a 'soft landing.'
Second, while it may be hard for us to imagine, things might actually have turned out a whole lot worse.
Goldman Sachs might well have relied on Prof.
Johnson's sophisticated, bullish forecasts rather than on John Paulson's intuitive short-side skepticism.
How much money would Goldman's clients, investors, and the rest of us have lost then?
© JSH, SubmergingMarkets, 2010.
Tuesday, November 10, 2009
True Unemployment: 20% and Still Rising Send Geithner Home to Wall Street! His Legacy: 30+ MM Underemployed, Failed Stimulus, No Bank Reform, Soaring Deficits, Sinking $$ James S. Henry
With official US unemployment now at 10.2 percent, the third highest among the 29 OECD countries, and unofficial unemployment at least two times higher, more than 30 million American workers and their families are now being forcefully reminded every day that "the reserve army of the unemployed" is not just pure Marxist rhetoric.
While China and most developing countries are already recovering nicely from this First World-made debt crisis, all indications are that US unemployment is still rising, and that we will soon see a new postwar record -- -- two years after the "Great Recession," the longest and deepest since the 1930s, began in December 2007.
UNEMPLOYMENT: GET REAL
To get the real unemployment picture, we need to adjust the official statistics upwards. First, as the Bureau of Labor Statistics' own data shows, the "official" rate leaves out many workers who are (a) underemployed, working only part time when they'd prefer full time jobs (9.3 million now); (b) fully unemployed, and desirous of jobs, but not counted in the official statistics because they've given up look (2.3 to 5.6 million). Allowing for these two adjustments already boosts "underemployment" to the 17.5% figure cited in some recent press reports.
But even that figure is too low. First, it omits the country's 20 million "self-employed" (incorporated and unincorporated), a growing share of the labor force. All are counted as "employed" in the official statistics, no matter how underutilized they are. Yet other surveys report that this group is also experiencing serious underemployment.
Furthermore, the official statistics also leave out about 1.6 million who are now serving in the military, plus the record 2.33 million US prison inmate population. Both populations are heavily young, male, and undereducated, and would therefore experience relatively high unemployment. This is especially important for the sake of historical comparability -- say, for comparisons with the 1930s, when the US military and the prison populations were both tiny.
In addition, of course, when the Great Recession started there were at least 8 to 10 million undocumented workers in the US, none of whom appear in the official statistics. Whatever we think of illegal immigration, the fact is that most of these workers have not been able to return to their homelands, and are still here, quietly suffering through this recession. Indeed, to the extent that they are unable to draw on unemployment benefits and other social programs to cushion the blow, they are being forced to compete with the rest of us more fiercely than ever.
All told, therefore, as shown in the adjacent chart (click to pop up), this makes the "real" US unemployment in October 2009 at least 20 percent or more -- twice the official rate.
TO WHOM DO WE TURN?
One might have expected this historic jobs crisis to have provoked a quick, decisive response from Washington Unfortunately, American workers have also recently been reminded that, disturbingly, the Democratic Party can simply no longer be counted on to put labor's interests ahead of capital's.
This was evident to some of us when Obama's first stimulus package was being designed -- given that it was loaded up with so many Christmas goodies for special interests and so many regressive tax cuts.
But by now it should be clear to anyone but the most bullet-headed diehard party ideologues.
Whatever else Obama's February 2009 stimulus package has accomplished, it simply hasn't created nearly enough new jobs, fast enough.
Nor has it provided nearly enough aid to debt-ridden homeowners -- as the continued record-setting pace of home foreclosures and bankruptcies testifies.
These basic policy shortcomings are not due to some Herbert Hoover or Ronald Reagan. While Obama obviously inherited a mess, by now enough time has passed that his administration has become responsible for its continuation.
How high does unemployment have to go for the Obama Administration to actually want to do something more about it?
When FDR took office in March 1933, unemployment stood at nearly 25 percent of the labor force, and he immediately took decisive action to make sure that unemployment was reduced, by establishing targeted federal job creation programs, attacking anti-competitive practices by large banks and corporations, and making sure debt relief got through to small businesses, farmers, and homeowners.
What is it about the character of the Obama Administration that has made its response so different?
THE FIFTH COLUMN
As we've argued for some time (See "The Pseudo Stimulus," The Nation, February 3, 2009, and "Too Big Not to Fail," The Nation, February 23, 2009), one basic problem seems to be that Obama's Administration, unlike FDR's, has been overly dependent from the get-go on pro-Wall Street insider/ fifth columnists, captained by the Supreme "Jimmy Do-little"/ Andrew Mellon of the period, Treasury Secretary Timothy Geithner.
Not only has Geithner been far too slow to recognize that the first stimulus was woefully inadequate.
- ☛Opposed serious restrictions on executive compensation and perks for senior bank staff that are unrelated to performance;
- ☛Opposed clawbacks or windfall profits taxes on the hundreds of millions in stock options granted by bailed-out banks last spring;
☛Opposed the establishment of a new independent consumer protection agency for financial products;
☛Opposed forcing banks that have accepted US aid to accelerate lending to small business and homeowners;
☛Opposed proposals for a "Tobin tax" on financial transactions, as suggested by the UK and France, as a way of financing climate change aid;
☛Opposed G20 proposals to clean up a wide variety of tax haven abuses by major bank and companies around the globe;
☛Failed to achieve any serious reforms whatsoever of financial regulation, more than a year after the crisis;
☛Failed to get anywhere with the vaunted "toxic asset buyback" program;
☛Insisted that any reforms leave the ultimate regulatory authority in the hands of the US Federal Reserve -- an anti-democratic, pro-Wall Street institution if ever there was one, whose policy errors have contributed significantly to this costly crisis.
Of course at this stage, with US budget deficits at a postwar high, and controversial measures like health care reform, climate change, Afghanistan, and immigration still in stuck in traffic, plus a mid-term Congressional election fast approaching, it may well be too late for the Obama Administration to propose a second stimulus. If this were going to happen, it would have needed Treasury and White House leadership already.
Secretary Geithner, I'm told, already has multiple job offers from at least a half a dozen leading banks and hedge funds, so he will only profit from this exit -- which he probably anticipated all along.
By clearing the decks and bringing in a fresh team with some new, more progressive ideas, more daring-do, and independence, this could help prevent Obama from repeating Jimmy Carter's sad, rapid one-term involution.
In any case, when the history of the Obama Administration is written, it is worth remembering that at least a few progressives warned about all this very early -- the risks of adopting a "pseudo-stimulus," failing to aid small debtors and businesses, and failing to exert strong control over the banks.
Ultimately, that may be one of the biggest costs of this crisis -- the lost opportunity to show that Democrats really are still capable of providing the country with outstanding, disinterested economic leadership in times of crisis.
(c) SubmergingMarkets, 2009
Saturday, February 28, 2009
TOO BIG NOT TO FAIL? James S. Henry
(A version of the following story appeared in the Nation on February 23, 2009, here )
Or has the administration just been fighting the last war,paying far too much attention to ancient history, special interests, political correctness, and its own pre-recession agenda, in its programs to stimulate the economy, fix the banks and providing debt relief to homeowners?.
For lifelong students of the Great Depression like Federal Reserve Chairman Ben Bernanke and Larry Summers, it probably seems that Obama's economics team is on track.
In less than a month, Obama has pushed his record $787 billion stimulus bill through a highly partisan Congress. The resulting projected federal deficits will be even larger as a share of of national income than those incurred under FDR, until World War II. At a time when unemployment is rising sharply, this should be good news for the economy--- if the plan is sufficiently stimulating.
On February 10, Treasury Secretary Timothy Geithner announced a bold, if somewhat imprecise, $2.5 trillion program to relieve US banks of dodgy assets once and for all. Combined with trillions in other loans and guarantees from the US Treasury and the Federal Reserve, this is designed to avoid another costly Great Depression-type error, in which scores of banks were allowed to fail and credit markets seized up. If the plan really is expected to work, that should also be good news for the economy.
Bernanke also concluded from his lengthy studies of the Great Depression that the Federal Reserve had blown it way back then by keeping monetary policy too tight. So ever since last summer he's made the US money supply as loose as loose can be, ballooning the Fed's balance sheet to nearly $1 trillion and driving real interest rates down to zero, while pressuring his counterparts in Europe and Japan to folllow suit.
Obama's team also has emphasized the importance of avoiding the beggar-thy-neighbor "protectionism" of the 1930s--aside from a little "Buy American" language in the stimulus bill and a few remarks from Geithner about China. If loose monetary policy and tighter lips are sufficient for recovery, it should be just around the corner.
Finally, in the course of Obama's drive to pass the stimulus, he traveled to troubled communities in Indiana, Florida and Arizona and heard first-hand that millions of American homeowners and small businesses could use a little financial aid of their own right now. So Obama has committed $275 billion of the remaining TARP/"Financial Stability" funds to this purpose. In principle, this should also be good news for the economy--if we really believe that the plan has what it takes to stem the galloping pace of foreclosures and bankruptcies.
Obama and his team may really believe that their first month in office compares favorably with FDR's in 1933. Historical pitfalls have been avoided, and there has been no shortage of good intentions, optimism and action. The new president has also assembled a team that includes, by its own admission, the nation's brightest economists and its most experienced veterans of the Fed and the Treasury.
But something seems to be missing. During FDR's first few months in office, and well into his second term, he received an overwhelmingly positive response not only from the public at large but also from the stock market, despite the fact that FDR and Wall Street generally detested each other.
In contrast, the reaction of global stock markets and market analysts to Obama's flurry of policy initiatives has been overwhelmingly negative. In the past week alone, since the passage of the stimulus, the announcement of the Geithner plan and the president's new plan for mortgage relief, the stock market has declined more than 10 percent. Indeed, the country's largest banks and auto companies, which were supposed to be the beneficiaries of much of these new programs, are on the brink of bankruptcy.
So what's the problem? Actually there are several problems. The first, as I noted in part one of this series, "The Pseudo Stimulus," there really is much less to Obama's stimulus than meets the eye and far less than will be needed to head off the dramatic increase in unemployment that is fast approaching.
For reasons of political convenience and a desire to move quickly, Obama and his advisors decided to appease a handful of key Republican senators, rather than seize the bully pulpit and rally support around a larger, more direct spending package with more debt relief for homeowners.
Ultimately Obama succeeded in getting just three "moderate" Republican senators and zero House Republicans to support the package. (Eleven House Democrats also voted against it.) These votes were costly. The final bill ended up slashing almost $40 billion from the package, while boosting the share of tax cuts to nearly 40 percent--including almost half of all relief provided in the critical first year when it is essential to get the downturn under control.
Most macroeconomists still believe that under conditions of excess capacity, tax cuts generate much less employment per dollar of lost revenue than almost any kind of spending, because upper-income types will save the proceeds or use them to pay down debts. Furthermore, many of the tax cuts in Obama's bill are regressive, even allowing for his favorites, "Make Work Pay," the earned income credit and child care credit. This means their impact on jobs will be even more limited.
For example, of $214 billion of individual tax cuts in the first two years, $100 billion will go to the top 20 percent, while the bottom 60 percent gets $81 billion. Indeed, for one of the largest single tax cuts in the bill, the $70 billion reduction in the "alternative minimum tax," 70 percent will go to the top 10 percent, while the bottom 60 percent--including most unemployed workers--get .5 percent. So Obama's vaunted plan relies on this premier-class AMT cut, plus another $100 billion of business tax breaks, for 27 percent of its first two years of "stimulus."
On top of this, Republicans like Arlen Specter also have shown that they give no ground to Democrats when it comes to sausage-making. I won't repeat part one's list of trinkets, except to note that almost all the worst projects survived, and indeed were only enhanced by the solons' scrutiny.
As a former Minnesotan I'm all in favor of free WiFi for each and every one of the nation's two million farmers; I've also recently written here in glowing terms about the merits of government- sponsored research and development and "green housing." But this kind of spending has little to do with putting millions of unemployed people--most of whom are in urban areas--back to work.
All told, at least $200 billion of this stimulus spending, on top of the $200 billion of wasteful tax cuts, is not remotely related to the urgent goal of creating as many jobs as possible in the next twelve to eighteen months. The cause of recovery was hijacked by a weird coalition of environmentalists, energy companies, venture capitalists, public-sector unions, state governors, tax-cut nuts and other special interests.
The stimulus program was supposed to realize Obama's declared goal of saving or creating at least 4 million new jobs by 2012--even then, at the average cost of $200,000 per job. According to the Congressional Budget Office, even that level of job creation would only reduce the US unemployment rate by an average of less than one percentage point a year by 2012, for a cumulative reduction of 2.5 to 3 percent relative to the CBO's projections of what unemployment will look like without the program.
By the time the Senate got through with it, Obama's stimulus became much weaker. So most economists now agree that it will be lucky to create or save even an extra 2.5 million jobs by 2012--about a 1.5 to 2 percentage-point cumulative reduction in the official unemployment rate by 2012, at an average cost to taxpayers of $315,000 per job.
The contrast with FDR's focus on spending programs that really did put people back to work, is striking.
THE REAL UNEMPLOYMENT RATE
All the standard measures of unemployment are woefully inadequate, but the shortcomings change with the times. In good times, with tight labor markets, conservative economists find it satisfying to remind us that the degree of "involuntary" unemployment is probably overstated, because workers can afford to game the welfare system--for example, by collecting unemployment insurance while refusing reasonable job offers.
In hard times like these, however, official unemployment rates seriously understate the degree of slack and hardship in labor markets. For example, in addition to the 13 million people now unemployed (that's 8.5 percent of the labor force) another 7.8 million workers report that they are underemployed; at least 2.1 million to 5.9 million more (none of whom are collecting unemployment) say they're not in the labor force because they've given up looking. By another measure, the peak labor force participation rate, established when labor markets were very tight in 1999 and 2000, shows the potential supply of labor not counted as unemployed is even larger--10.6 million right now.
All told, this means by now there are already at least 23 million to 33 million American adults who are already experiencing increased unemployment, up from 13 million to 17 million from a year ago. By the end of 2009, as the official unemployment rate passes 10 percent and the other indicators of slack labor markets grow as well, this figure will swell to 40 million American adults--at least 9 million to 18 million more under-utilized workers than we have now.
A majority of these people have families. Furthermore, the unemployed population constantly turns over, with a median duration of joblessness that now exceeds ten weeks. This means that during the next year, up to one-third of the entire US population will personally encounter someone facing the harsh realities of involuntary unemployment, and perhaps homelessness and poverty as well.
These figures omit several other kinds of "hidden" unemployment that are not recorded in conventional labor force and unemployment statistics: the 1.44 million people on active duty in the military and the unemployment they would face if and when they return to civilian life; the 2.3 million inmates in federal, state and local prisons, all of whom are omitted from labor force and unemployment statistics; and the estimated 8.1 million undocumented workers in the United States who are in the labor force.
In many ways undocumented workers are the most vulnerable victims of the crisis. Most support families either abroad or home. Many also have been working hard here for years and have now lost their jobs, without any unemployment insurance, healthcare, rights to Social Security or other benefits. And since Congress has not been able to agree on a decent immigration reform bill, they may not even be able to count on achieving US citizenship, after years of working and waiting. Now they face a hard choice between remaining here, unemployed, or returning to violent, corruption-ridden "Bantustans" in Mexico, Central America, the Philippines and elsewhere.
It's important to take these factors into account when we consider how this downturn compares with earlier financial crises. Unemployment statistics for the 1930s are difficult to compare with our current situation, given the different statistical procedures employed and the very different demographics in the two eras. But my analysis shows that it is possible that this crisis may turn out to be comparable to the situation in 1933, when unemployment peaked at roughly 25 percent of the US labor force.
This analysis provides a context for assessing Obama's original goal of creating/saving 3 million to 4 million jobs by 2012. The fact is, even that original goal simply wasn't anywhere close to being ambitious enough--and it certainly won't be met under the sadly compromised final "stimulus" plan. The negative reaction of global stock markets markets to Obama's plans so far appears to confirm this. We're going to have to stop the political games and get serious.
GEITHNER'S TARP II
Markets reacted negatively to the plan not because investors necessarily opposed his new toxic asset buyback scheme. Most analysts felt that his long-anticipated statement was long on rhetoric about "stress tests and transparency" but short on digestible content--like being invited to dinner and then served pictures of food.
Indeed, like his website, FinancialStability.gov, Geithner's plan remains under construction. But critics may have missed the point--this lack of detail actually may be a political necessity. If the American people understood just how high a price the Obama adminstration may be willing to pay simply to keep our country's largest failing private banks private, we might need a few more guards at the Winter Palace.
Tim Geithner is not a former Wall Street insider in the Paulson/Rubin mold, nor was he ever for a single day a community organizer. He's an ambitious and cautious policy technocrat, whose lucrative private-sector career and board seats are still in front of him. We'd be hard-pressed to find anyone who, at age 47.5, had already punched more establishment tickets. His grandfather was a Ford Motor executive and Eisenhower adviser; his father is a Ford Foundation officer who raised Tim on three continents. He graduated from Dartmouth and Johns Hopkins, became a consultant for Kissinger Associates, a protégé of Robert Rubin and Larry Summers at Treasury in the 1990s, an IMF policy director in 2001-2003, a Council on Foreign Relations fellow and finally head of the Federal Reserve of New York. As of the end of 2008, he was still a member of the CFR, the Group of Thirty and the Economic Club of New York, organizations not routinely associated with sponsoring deep reforms in post-capitalist economies.
Geithner has seen his share of banking crises firsthand: Mexico in 1995, when the entire banking system had to be re-nationalized; Thailand, Indonesia and Russia in 1997-98; Argentina in 2001; and now the biggest one of all right here. All of the Third World crises just noted ended badly--costly, poorly-managed fiascos that did nothing to enhance the reputations of the US Treasury and the IMF. But perhaps Geithner was just an apparatchik. He worked closely last year with Hank Paulson and Bernanke on Bear Stearns bailout, the Lehman/Merrill decisions, the AIG takeover and TARP I. So he probably understands full well not only the gory details of program design but also two fundamental political realities.
The first is that while nationalizing top-tier global banks may be politically acceptable in places like Norway, Sweden, Chile, Iceland, Ireland and even Japan and the UK, it is still viscerally opposed by most members of the power elite in New York and Washington--including most of his former club members.
The second is that by now, most American taxpayers have simply had it with huge Wall Street bailouts, supine members of Congress, overpaid banker chutzpadiks and high-handed Treasury secretaries. If they were ever asked, there is no way in Naraka that taxpayers would ever approve yet another open-ended injection of public capital into banks--especially one costing three times the entire "stimulus" and three-and-a-half times TARP I.
So the trick is to not ask them. With bank stocks sinking every day, the credit crunch hampering recovery and high expectations about policy changes, Geithner had to say something. But not too much. The whole subtext of his vague announcement was to finesse the question of precisely where all the money would come from. The hope was that this would buy time to line up private capital, perhaps by negotiating some kind of insurance subsidy that would induce it to participate. The hope was that this would do enough to stem the decline in bank stock prices and redirect attention away from the new "N"-word--nationalization.
WELFARE FOR BIG BANKERS
Of this, more than half went to the top fifteen banks in the country. This includes $145 billion of capital injections awarded to Citigroup, Bank of America, JP Morgan and Wells Fargo, the top four US commercial banks; another $10 billion each for Goldman Sachs and Morgan Stanley, two worthy investment banks that decided to become commercial banks to avail themselves of federal aid; and a grand total of $84 billion to the rest of the US banks. There was also $40 billion in capital injections and $113 billion in credit in AIG, the profligate insurance company that sold so many flaky credit derivative swaps to investment banks like Goldman that it pioneered a whole new new "too fraudulent to fail" rule. In addition, by now US banks have also received at least $1.82 trillion of federal loan guarantees and $872 billion in federal loans.
These sums need to be viewed in the context of the staggering amount of government assistance that has recently been provided to private financial institutions all over the world. By February 2008, by my reckoning, banks and insurance companies have already absorbed at least $817 billion of government capital injections, $251 billion of toxic asset purchases, $2.6 trillion of government loans and $5.9 trillion of government debt guarantees. If we added the guarantees for once quasi-private entities like Fannie Mae and Freddie Mac, the loan guarantees double to $10.9 trillion.
To put all this in perspective, the 1980s savings and loan crisis cost taxpayers from $150 billion to $300 billlion in comparable 2007 dollars. The 1998-99 Asian banking crisis cost $400 billion. Japan's prolonged banking crisis in the 1990s cost $750 billion. And the total amount of debt relief received by all Third World countries on the $4 trillion of dodgy foreign debt that they incurred from 1970 to 2006 was just $310 billion.
Those crises are completely over, while this one is still unfolding, so its ultimate cost is still uncertain. Already it is clear that ordinary taxpayers around the world are on the hook for total losses that will easily dwarf all the costs of all these other recent banking crises combined--including $2 trillion to $4 trillion of further bank write-offs beyond the $1 trillion of losses already recognized. Since no government on earth has the surpluses on hand needed to fund such largesse, this means that we will be paying for this bailout one way or another for the rest of our lives, and probably for our children's lives as well, through increased inflation, taxation and reduced government services.
Never has so much been given to so few by many. Yet despite all this public generosity, much of the US banks' recent behavior been execrable. For example, in December we learned that the US Treasury got preferred securities in exchange for the first $254 billion of TARP funds that, right off the bat, were worth $78 billion less than the funds they received.
We've also watched with amazement as they've continued to fund corporate jets and other perks, and as several of the largest recipients of TARP funds have paid extravagant bonuses to senior executives for "performance" in 2008--a year when the banking industry contributed mightily to the tanking of the entire global economy. Nor have most banks been forthcoming about what they've actually done with all the TARP money--except to to concede that they haven't done much new net lending. After all, they say, in this economic environment, with regulators suddenly breathing down their necks about leverage and toxic assets, they are not eager to take risks.
That's all well and good at the micro level, but at the level of the overall economy, we badly need banks to swallow hard and start churning out new loans--and not just to gold-plated borrowers who don't really need the money. Since TARP I funds were not dedicated to new lending, and, indeed, since policy makers like Paulson, Bernanke and (presumably) Geithner decided to leave TARP I's use entirely up to the banks' discretion, this period of extreme largesse and low interest rates has also coincided with tight credit markets--except for well-off corporations and elite borrowers and refinancers, who have actually been the main beneficiaries of Bernanke's low-interest rate policy.
So while both the Federal Reserve and the Treasury have been busy demonstrating that they have finally taken the lessons of the Great Depression to heart, and have been setting records for generosity and loose lending, at the end of the day they still allowed the private banking system to keep its elephant in the hallway, blocking the road to recovery.
Since October 2008, the net worth of the entire US banking system-- all 8,367 domestic-owned US banks--has declined by $420 billion, to just $540 billion. In other words, TARP was one of the worst investment decisions in corporate history--the banks' net worth has declined by more one dollar of equity value for each additional dollar of TARP funds injected.
Indeed, the net worth of two of the largest banks in the system, Citigroup and Bank of America, is now around $30 billion, less than half of the $70 billion in government capital that they have received from TARP I, on top of $424 billion of federal loan guarantees. Not only has their own "value added" during this period evidently been negative. For a fraction of the funds we've given these two banks, we could have stopped begging them to clean up their balance sheets, restructure their mortgages, stop wasting money, change their compensation plans and initiate sensible new lending programs. We could have bought a controlling share, hired new management from the droves of idle bankers now out on the street and re-privatized them at a profit for taxpayers in two to three years--just as successful "turnaround nationalization" programs have done again and again in these situations, from Norway to Chile.
No wonder that growing numbers of critics--not just hard-core lefties and Nobel laureates like Paul Krugman and Joseph Stiglitz but even pragmatic politicians like South Carolina Republican Senator Lindsey Graham--have started to break the taboo and talk explicitly about "nationalization."
But in an important sense the taboo had really already been shattered by TARP I, last year's expansion of FDIC deposit insurance and all the other new federal loan guarantees for the bank. In effect, these already "nationalized" the banks' debts. Now we're just talking about the other side of the balance sheet, where there might at least be some value, if only under new management.
Geithner is hardly unaware of this short-term nationalization approach to the credit crunch, or of the success it has in many other markets. But he has apparently rejected it in favor of a much more costly and uncertain route--establishing a public-private bailout fund that will somehow entice the banks to sell off their lousy assets and still have enough equity left to survive as private entities.
The limitations of this approach are best understood by taking another close look at Citigroup and Bank of America, two of the most troubled institutions in this story. On their most recent balance sheets reported to the FDIC, these two big banks alone accounted for $4.1 trillion of official on-balance-sheet "assets"--mostly loans and federal securities, but also a hefty amount of potentially dodgy mortgage-backed securities and other asset-based securities.
Right off the bat, therefore, at least by the accounting numbers, these two top banks alone now account for more than 30 percent of all the assets outstanding in the entire US banking industry. Indeed, the top fifteen banks account for over 60 percent. This represents an incredible increase in banking industry concentration since the early 1990s, when Citibank and Bank of America held just 7 percent of all US bank assets, and the top fifteen banks held 21 percent.
This increase in industry concentration was hardly an accident. It originated in the desires of bank executives to grow, boosting market share, short-term earnings, stock prices and the executive bonuses driven by those metrics. But it also reflected the gloves-off stance that Congress, regulators and antitrust enforcement took toward bank expansion during this period. And that, in turn, was probably related to the more than $1 billion contributed by the financial services industry, their lobbyists and law firms, to politicians of both major parties since 1990, which turned the Senate Banking Committee the House Financial Services Committee and other key Congressional committees, in effect, into wholly owned subsidiaries of the banking industry.
Now how much might all these assets on the banks' balance sheets actually be worth? There is no active exchange for most bank assets, especially those that are hardest to value in this environment, like mortgage-backed securities. And by law, the banks are permitted to value the assets on their books at "fair market value"--in essence, whatever their accountants tell them they are likely to be worth, given historical experience with loan losses. But the difference between these accounting numbers and today's market value for these assets may be huge--up to half or more of book value. And the banks have a strong incentive to hold on to the loans and hope that things get better, rather than sell them off right now at whatever the market will bear. After all, as soon as they start selling down one loan bundle, they may be required to "mark to market" all similar ones. And the resulting writedowns might well be enough to wipe out all stockholder equity, leading to insolvency.
This whole situation is reminescent of the 1980s Third World debt crisis, when banks like Citibank, Morgan and Chase resisted for years the demands of policy makers and developing countries to write down or sell off the billions of overvalued loans on their books--for no other reason than, as one former Chase banker put it, "a rolling loan gathers no loss." Similar behavior occurred during the prolonged Japanese debt crisis of the 1990s, when banks stubbornly resisted the efforts to get them to "mark to market" because several of them realized they would be bankrupt and no longer with us if they did so.
There's not really much moral culpability here. At ground level, from the standpoint of any individual bank, this behavior is understandable. After all, they have just gone through a period of careless underwriting, and are trying to reduce their loan losses and improve their capital ratios--just like most bank regulators want them to do. The larger banks have balance sheets that are best described as follows: "On the left side (assets), nothing is right; on the right side (deposits and other capital), nothing is left." And since the economy is still slipping at an unpredictable pace all around them, no loan officer is eager to take on more risks. So it is hardly surprising that in the last quarter of 2008, even as the TARP money started to flow, US bank lending suffered its sharpest decline since 1980. It also makes perfect sense for them to resist selling off its loans and securities at what may eventually turn out to have been fire-sale prices.
While all this may be well and good for bankers, however, for rest of us it means that even after all those trillions in federal bailouts and loan guarantees, the economy is still starved for credit. The fact that major banks as a group continue to sit on all these lousy loans at book value, rather than selling them off and writing them down, means that they don't have much room on their balance sheets and in their capital/asset ratios for new loans. So the credit crunch continues. And banks that we eventually may find out were really insolvent may walk around in a trance for months or even years, like a scene from Night of the Living Dead. We're not talking about restoring the loose lending of the 2005-2007 bubble; we're talking about the essential liquidity needed to keep the wheels from coming off, stimulate demand and stem the decline in housing prices.
But these potentially troubled categories of assets only add up to about $1.6 trillion; why is Geithner talking about a $2.5 trillion program? The FDIC's latest statistic a provides a clue. It reveals the dominant role that the country's top banks have also played in issuing derivatives, including not only interest rate and currency swaps, but also in more notorious debt-based over-the-counter derivatives. As of September 2008, JPMorganChase, Citigroup and Bank of America accounted for an incredible 90 percent of $7.9 trillion of these "off-balance sheet" credit derivatives that have been guaranteed by these banks themselves--including $2.6 trillion guaranteed by B of A and Citi. So when Secretary Geithner was talking about running "stress tests"--scenarios for future housing prices, default rates and interest rates--against the balance sheets of particular banks, he was not talking about First Federal of Tuscaloosa or Suffolk County National in Riverhead. They've probably never guaranteed a credit derivative in their lives, much less tucked anything away in some Cayman Island "special purpose vehicle." Clearly, Geithner had his friends on Wall Street in mind.
REALLY A POLITICAL PROBLEM
In short, we have a choice to make: we can spend perhaps $150 billion to $200 billion buying out the equity of a handful of leading banks that have gotten themselves in this mess and reform them. This would involve taking them over immediately, installing new managers, giving their creditors a haircut, writing down the toxic assets (which the government-owned bank could do without fear of market reactions) and then preparing them for privatization when the market recovers.
Or we can follow Secretary Geithner's lead, fiddle around for months, throwing trillions more of government capital, loan guarantees and portfolio insurance at the problem, without any guarantee that the resulting cockamamie approach to creating a "public-private" toxic bank will ever work--while the same old troubled institutions are left standing, no longer encumbered by their dodgy assets perhaps, but still encumbered by dodgy managements.
There are lots of technical issues to be weighed in making this choice. But after reviewing all the objections to the kind of short-term, temporary, partial nationalization, I'm convinced that the most important issues are simply political, a choice between our commitment to a failed, hands-off model of bailouts and banking regulation and decisive, FDR-like action.
It is precisely because it is so hard to value these dodgy assets at all that we are even having this discussion. Given the absence of competitive markets for the assets, the uncertain environment and their dependence on taxpayer subsidies and insurance, the prices established are intrinsically political. Either they will be set so low that banks will have to take such massive writedowns that their shareholder equity will disappear entirely anyway, or--more likely--the prices or insurance arrangements will be set so that even more taxpayer wealth is transferred to these very same top-tier banks.
Meanwhile, the whole economy is hostage to this decision. We have no time to waste. We should get on with it, making use of one of the clearest market signals available in this situation--the current value of Citibank and Bank of America shares.
This argument is not at all anti-market, or necessarily even anti-bank. At their best, private markets, entrepreneurship and innovation are absolutely essential. My real objection is to a very specific kind of bank-dominated political economy. To call this "capitalism" is to have Ayn Rand and Friedrich von Hayek turning somersaults in the crypt. Time and again, this pathological form of pro-bank development has jeopardized the prosperity, stability and innovation of the small businesses, inventors and would-be savers who are the backbone of market economies. Bank-dominated political economies don't really deserve to be called "capitalism," since big bankers have never really been entrepreneurs who are content to stick to the capitalist rules of the game. Instead, they periodically demand the divine right to take unlimited risks, privatize the resulting gains and stick the rest of us with any resulting losses.
It is time for accountability, we are told by our new president. If so, we should start by holding the world's largest banks, hedge funds, insurance companies, mortgage brokers and private equity firms, together with their many friends in accounting, law, public relations, credit rating, central banking and higher office accountable for this crisis--if in no other way than by refusing to award them this even more massive TARP II bailout, permitting them to rob us, once again, with both hands.
Wednesday, February 04, 2009
(This article appeared in The Nation on February 4, 2009 here.)
First of a three-part series on the economic crisis.
You, telling me the things you're gonna do for me.
I ain't blind and I don't like what I think I see.
--Michael McDonald, The Doobie Brothers,
"Takin' It To the Streets"
So now that President Obama is in office, his economic team is in place, the largest stimulus package in US history is nearly complete, real interest rates are negative and the Treasury is about to announce a "big bang" version of TARP that provides even more capital to private banks, we're good, right?
Lo siento, no, as shown by last week's steep stock market slide, even after his program passed the House. For once, the Republican wingnuts may be right. There really is much less to Obama's stimulus than meets the eye.
His new plan for ridding the banks of toxic assets--"cash for trash," as economist Joseph Stiglitz has aptly described it--is also likely to be way too kind to bank executives and shareholders, and he appears to be remarkably ignorant about the indisputable successes that capitalist countries like Norway, Chile, and Japan have had with temporary, partial bank nationalizations that make the taxpayers "owners of last resort."
There has been far too little debt relief provided to the growing number of homeowners facing foreclosure, small business owners facing bankruptcy, and other debtors. This step is urgently needed to stem the free fall in housing prices and the rising tide of layoffs among small businesses, where most of the country's jobs are.
There are rumors afloat that Obama's team may soon announce something like this, but the numbers that we've heard from key Congressmen--$50 billion to $100 billion--are far too modest. We need to pressure the president for a "People's TARP," no less generous than the ones that the banks are receiving.
Finally, while US policymakers have been throwing gargantuan sums of borrowed money at the wall, mollycoddling Wall Street, and dithering on debt relief for the rest of us, the global crisis has deepened. All across Europe and Asia--from Athens, Chongqging, London, Moscow, Paris and Prague, to Rekyavik, Riga, Seoul, Sofia and Vilnius--people have become completely fed up with their governments and are taking it to the streets.
So here's a message for our new president, from someone who worked hard for his election long before it was fashionable: if you dally and temporize, the very same thing could easily happen here--perhaps just in the form of a massive tax strike, in solidarity with Messrs. Geithner and Daschle.
While Americans are usually much less militant and certainly less well organized than our comrades around the world, the serious deficiencies in the first drafts that we've seen of Obama's stimulus and financial plans really do need to be corrected in short order.
We also need to see much tougher action with the financial services industry, which bears a disproportionate share of the responsibility for this nightmare. At a minimum, this means a return to a more orthodox and tightly regulated banking system, a renewed assault on tax havens and the anarchy of the world's financial order, strict limits on executive pay plans that reward unbalanced risk-taking, and a 1930s Pecora Commission-style investigation of the industry's misbehavior--complete with subpoena power.
In the words of FDR's first inaugural address in March 1933--which, by the way, was harder-hitting and much more memorable than Obama's--it is time for the "money changers" to be forced to flee from "their high seats in the temple of our civilization" once and for all. The only thing we have to fear is Obama's temerity.
By now everyone has had just about enough bad economic news, but just to set the stage for the discussion, it is important to review the basics.
It's is already a cliché to describe this crisis as "the deepest global downturn since the Great Depression." Actually in many ways it threatens to become even worse--faster, sharper and far more global. Here at home there are already more than 11.1 million unemployed, close to the 11.4 million peak that was reached in 1933, when 20 percent of the population still lived on farms and, apart from the Dust Bowl and bank repossesions, could at least count on having a place to grow their own food. In 2008 alone there were already 2.3 million residential foreclosures filed and 861,664 completed in the US, compared with the 600,000 total that was recorded from 1930 to 33. Obviously, relative to the size and wealth of the economy, conditions were worse back then, partly because the social welfare system provided less help and more bank depositors got wiped out. But in absolute terms the sheer number of our fellow citizens who are already experiencing serious hardship is really disturbing. And we are only a few months into this.
Since October, growth rates have plummeted and unemployment has soared worldwide. Just last week, the International Monetary Fund cut its latest forecast for world growth in 2009 to .5 percent, and for the United States to negative 1.6 percent, as fourth-quarter US growth plunged by over 5 percent, apart from inventory accumulation. Other credible observers are far more gloomy.
Each day brings news of massive layoffs, corporate losses, foreclosures, the bankruptcies of well-known brands like Waterford Wedgwood and Circuit City, continuing house price declines, bank failures, abandoned projects, soaring government deficits and bailouts and widening spreads on loans to some First World countries, not to mention financial frauds, robberies, suicides and other indexes of deep financial distress.
This is the world's first post-globalization debt crisis, and the
worldwide effects are catastrophic. From Labuan, Jakarta and
Guangdong to Chicago and Detroit, London and Moscow, the ranks of the
unemployed are expected to swell by 51 million by mid-2009, and of those
living in dire poverty by at least 176 million. Beyond impersonal
statistics, there are also innumerable tragic stories of personal
hardship, involving people and families that have suddenly lost jobs,
careers, businesses, homes, life savings, healthcare, scholarships
and, most important, hope for the future.
WHAT ARE WE STIMULATING?
Given this situation, the US economy's influence on the global situation, and the importance of resetting expectations, the stakes for Obama's very first economic initiatives are enormous. Unfortunately, the first drafts already adopted by the House and under debate in the Senate are disappointing.
Surely, at these prices we deserved a much more carefully targeted anti-Depression program. Instead, over 63 percent of Obama's $825 billion-plus in new spending and tax cuts won't even be felt for at least a year, and more than $100 billion won't show up until 2012 or beyond. Even if the plan works as advertised, it would only reduce unemployment by less than one percentage point a year, relative to the more than 9 percent baseline projection we are facing.
But this plan will almost certainly not work as advertised. It has been weighed down with $275 billion in tax cuts that would have very modest short-term multipliers. At least 21 percent to 25 percent of Obama's tax credits would go to recipients in the top 20 percent, with incomes above $113,000. These folks are more likely to save the money than those with lower incomes--and right how what we need is spending, not saving.
Evidently these tax cuts were included out of some broad-minded attempt to reach out to Republicans and Blue Dog Democrats. One might have thought they were already sated by a decade of record tax cuts for upper-income groups, starting with Bill Clinton's sharp reduction of capital gains taxes in 1997--even larger, by the way, than George W. Bush's. But Obama's diplomatic gesture yielded not a single Republican vote in the House last week, and also failed to win over eleven Democrats. Welcome back to Earth, Mr. President.
Even Obama's $550 billion of extra spending will not be sufficiently stimulative. First, around $200 billion will be channeled through state aid. On average, this will have an even lower multiplier than tax cuts, because of bureaucratic delays and the fact that our political system always channels a disproportionate share of aid to less-needy states. At one end of the spectrum, six states with unemployment rates above 9 percent now account for about one-fourth of the nation's unemployment--2.8 million people. Under Obama's program these states would get less than 20 percent of all this state-channeled aid, an average of $8,623 per jobless person. But ten mainly Western states with unemployment rates below 5 percent will get nearly $20,000 per unemployed person.
Second, despite the sales rhetoric about promoting recovery and saving jobs, these were clearly not the plan's only--or even its most important--objectives. If they had been, there'd be far more up-front spending on direct job creation and programs with higher multipliers and faster paybacks, like unemployment benefits and populist debt relief. There'd also be more top-down control.
Instead what we have is a dog's breakfast of pet projects, spread across 104 federal agencies, from the Administration on Aging and the Bureau of Indian Affairs to Fish and Wildlife and the National Endowment for the Arts. Dozens of projects were evidently extracted from various liberal wish lists, dusted off and dressed up in the latest "recovery-jobs" couture. Almost anything can qualify so long as it carries a big enough price tag: digital TV conversion ($640 million, on top of the $1.3 billion already spent for this worthy cause), port security ($600 million), research on biomass and geothermal ($1.2 billion), constructing the "smart grid" ($4.4 billion), climate science ($390 million), fixing Amtrak ($800 million), developing satellites ($460 million), restoring wildlife habitats ($400 million), preserving forest health ($850 million), special education ($13.3 billion), immunization ($954 million), STD prevention ($350 million), water projects ($13.7 billion), preparing for a flu pandemic ($620 million), grants to local police ($4 billion), advanced batteries ($2 billion), wireless broadband ($6 billion), a new data center for Social Security ($400 million)...
The overall impression is a parody of bloviated corporate liberalism. It is as if every deep-sea creature in the ocean suddenly came to the surface at the same time. There they all are, writhing and waiting for someone to make sense of the overall game plan.
Road and bridge repair be damned! Why worry about being unemployed when there's so much else to do? Soon we'll all be firing up the clean-coal stoves and sewage-fired generators, recharging our federally subsidized Volts and the underground battery farms and heading on over to new neighborhood health centers, where we'll download some interactive broadband training on aging and avoiding STDs. Then perhaps we'll plant a tree or apply for grants to "weatherize" or found a "rural enterprise." By then it will be time to pick up Little Dorothy at Early Head Start, get her vaccinated, say hey to the new federally funded "local" police chief, artists and high school teachers, then kick back in front of the converter box with a long cool draught of federal H2O and a generous helping of nutritious cuisine from the "local" Emergency Food store--making sure that the CO2 that we generate is properly sequestered and not bubbling up through the neighbor's brand new geothermal system.
By the laws of probability, of course, at least a few of these schemes may actually turn out to have some merit. But it is clear that Washington's finest lobbyists and law firms--second only to Wall Street in terms of sheer venality--have already been hard at work to insure that no key client has been left behind: electric utilities, the coal industry, telecoms, agribusiness, the IT industry, the teachers unions, the Asphalt Pavement Alliance, the Portland Cement Association ("we pour strength into our recovery"), commercial real estate developers and even venture capitalists, are all lined up to profit from Obama's extraordinary spending spree.
I'm beginning to sound like a Republican wingnut. But really, at lightning speed, we've gone from booting single mothers off the dole in the interests of "personal responsibility" (saving a grand total of--what, Bill Clinton?--maybe $5 billion per year at most, while finding jobs for only half of the 60 percent who got the boot) to having almost every single key interest group in the country lining up with a tin cup, right behind the banks.
More important, from a global perspective, Obama's program takes the eye of the ball. What the world economy desperately needs most right now from the US economy--remember, we're the ones who originated this debacle--is not "reinvention," or some hastily-assembled collection of alternative energy demonstration projects, but a good, old-fashioned healthy US market recovery.
Once that is in place, there will be plenty of time and money to save the planet. But unless that is in place, there will be no serious worldwide attention paid to climate change, global warming or alternative energy, nor will there be necessary funds and economic incentives that are required to really fix the the problem. At a time when tens of millions are having a hard time feeding their families, these are luxury goods. I defer to no one in my hardcore environmentalism--but Obama's plan has had a little bit too much input from Al Gore's "green limousine" set, and is putting the green cart before the debt-ridden horse
In fact, this program somehow manages to be neither reinvention nor recovery. Nor is it very thoughtful. Rather, it is a Jackson Pollack approach to social and economic policy. That kind of action painting may have been OK for hip Hamptons artists way back in the 1950s, but in these times it is dangerously blithe. It also risks discrediting everything that progressives should stand for, if we want to see government taken seriously again as an agent of social change. If we continue with this scattershot, favorite-liberal-interest-group approach, creditors like China may soon begin to wonder whether we've become just another Banana Republic--not the chain store, but the political pathology--or an aging superpower that has an acute case of ADHD.
Of course it is easy to criticize. The real test is to come up with a superior, politically feasible alternative. Later on in this series, I'll suggest one--a combination of high-multiplier spending and serious popular debt relief that would command more support, provide a much greater direct stimulus, stem the decline in housing prices and small business closings and placate foreign creditors who are worried about our sanity. It might even permit Obama to finally win a few Republican votes for his program.
Monday, November 03, 2008
INVEST IN INNOVATION!!! Instead of Eating the Seed Corn... James S. Henry and Jim Manzi
We are called the nation of inventors. And we are. We could still claim that title and wear its loftiest honors if we had stopped with the first thing we ever invented, which was human liberty."
-- Mark Twain
(The following is a longer version of a piece that appeared this week in The Nation.)
In the midst of our deepening recession, the US faces another economic crisis that is less visible and dramatic than house foreclosures, bank failures, plant closings, or stock market avalanches, but even more important in the not-really-that-long run: systematic under-investment in technology and innovation.
Indeed, nothing less than our global economic leadership may be at stake because of this underinvestment.
On the other hand, with a little bit of funding, foresight, and determination, we believe that it may be possible to kick-start an innovation revival.
Especially at the federal level, for a modest investment, there’s an opportunity to create a whole new generation of idea-growing, job-creating technology hubs all across the country – perhaps even an “automotive Silicon Valley” in otherwise moribund Detroit.
This revival would not just be about investing more heavily in R&D. Especially in troubled times like these, we need to remind ourselves that innovation has always been a critical American tradition, a crucial part of our patrimony. It is as much a by-product of our political system and cultural norms as of our business and scientific practices.
This patrimony is now at risk, not only from our failure to invest, but also from the failure to reward and honor scientists, technicians, engineers, and inventors above lawyers, bankers, and hedge fund managers, and to recognize the central role that real innovation of all kinds has always played in our story.
For more than two centuries America has led the world in innovation. This has been true not only in science and technology, but also in business management practices, the design of new approaches to service delivery, and, indeed, sports, political institutions and civil rights as well. Over the long haul, this consistent track record of ingenuity and invention, complemented by heavy investments in education and science, has contributed mightily to America’s leadership role in the world economy, to our democratic culture and the prosperity of our people.
Indeed, most students of economic growth now agree that the contribution of technical innovation to US national wealth has been at least as important as that of so-called “natural” resources like abundant farm-land, labor, capital, and energy.
In the post-globalization economy, where access to such resources is being commoditized, innovation has become an even more important source of competitive advantage. In principle, this should be good news for the US. This is not only because of its past successes, but also because innovation-based competition is “win – win,” not “beggar thy neighbor.” Over time, every player in the competitive game stands to benefit from the discoveries made by others.
On the other hand, if the US stakes its future on resource-based competition -- or the kind of low-innovation, “big houses/big debts/big cars” model favored by Detroit, New York, and Houston until very recently -- the competitive game will become “win-lose.” And long-term competitive advantage then shifts to those countries with the largest supply of cheap resources, the lowest taxes, and the cheapest, most oppressed workers -- not a favorable formula for a healthy democracy.
To begin with, virtually every analysis of the “social returns” -- private profits and social benefits, including employment -- to R&D investments finds these returns to be very high. They average at least 30- 50 percent per year or more in real terms, compared with the meager 5-7 percent returns typically generated by the US stock market – or the minus 46 percent returns earned by stocks earned in the last year.
These high returns to R&D are explained by its peculiar nature. Once discovered, new ideas can be used over and over at low – or even zero – marginal cost. So R&D not only boosts productivity in the industries that do research; it also yields “spillover” benefits for other industries. And it speeds up future innovations. There is NOT a finite body of good ideas sitting out there waiting to be mined. Rather, from a knowledge standpoint, we live in an expanding universe, where each new discovery reveals whole new territories to be explored.
Consistent with this, those industries that are the most R&D intensive have also consistently achieved the highest growth rates and profitability, and have also made the largest contributions to skilled employment and high incomes. The notable exceptions -- financial services, lawyering, real estate development, accounting, plus cartelized industries like autos, cable television, and oil and gas -- are ones where clever chicanery, market power, and anti-competitive regulations have permitted vast fortunes to be achieved without much fundamental innovation at all –- until the recent collapse.
THE INNOVATION GAP
These high rewards for investments in R&D also suggest the presence of a substantial innovation spending gap. This is the gap between the current level of R&D spending and the optimal level, from the standpoint of generating growth, employment, and the many other social benefits of new ideas. Indeed, we are so far from the competitive margin that the US might be able to profitably invest several times the current $370 billion per year that US industry and the federal government now spend on R&D without driving “social returns” below the long-term (federal) cost of capital – just 1 percent these days after inflation.
Let’s put it this way: at these interest rates, and the high expected returns, it would cost the US Government just $400 million per year in interest to double its entire current budget for civilian R&D – which might then yield an incremental $12 billion in returns. It’s about time that we realized such high multiples for the country, and not just Wall Street executives.
Yet the recent trend in US R&D investment has been in precisely the opposite direction.
First, while US R&D spending as a share of national income has been relatively high for decades, compared to other Western countries, since the mid-1980s it has stagnated. Indeed, it now is well below the 1960s level, when the Kennedy/ Johnson Administrations’ visionary drive to reach the moon, combined with the arms race and the rise of mainframe computing, produced a sharp boost in US R&D spending.
Federal funding is one key to this gap. While it still accounts for about 28 percent of all US R&D spending, it has recently been especially sluggish. In real terms, the federal budget for basic and applied R&D has fallen for five years in a row, and will continue to slide next year under the budget just approved by Congress.
This recent trend is even more disturbing, once we take into account the fact that nearly 60 percent of the Federal Government’s current $100 billion of R&D funding is devoted to military and “national security” programs at the Pentagon, DOE, and the Department of Homeland Security.
The $42.6 billion left over for non-military research in FY 2009 has to fund everything from DOE’s basic research on alternative energy to the National Institute of Health’s vital medical research program for peer-reviewed science, to NASA’s entire space budget. As a share of national income, non-military budget for R&D now amounts to a paltry .3 per cent – the lowest share since the early 1950s, and just half the average in the late 1970s.
The $43 billion budgeted for all federal civilian R&D pales by comparison with the $700 billion that the US Treasury is injecting into US banks, in return for some combination of non-voting stock, very low dividends, and toxic assets. It also pales by comparison with the $29 billion bailout of Bear Stearns, the $135 billion bailout of AIG, the $200 billion bailout of Fannie Mae and Freddie Mac, let alone the $800 billion cost (to date) of the Iraq War.
But of course that must simply be because government R&D spending is a risky venture whose outcomes are highly uncertain!
DON’T LOOK BACK
The other disturbing point about R&D spending is that American leadership has been slipping. Relative to other countries, the US has long devoted a relatively high share of national income to R&D investment. Even now it still accounts for a disproportionate share of all global R&D -- at least 25 to 34 percent.
However, while US R&D spending has recently stagnated, many
other countries, including key new competitors like China and Malaysia
as well as more mature ones like Korea, Singapore, and the Nordic
block, have been sharply increasing R&D spending. So the gap
between these leading competitors and the US in overall R&D
spending is rapidly shrinking.
Since innovation is by definition a matter of human skill and creativity, not just finance, it also matters that these new competitors have also sharply increased the share of skilled researchers and technicians in their labor forces. The US’ slippage has also been aided by the “hegemon tax” -- the fact that none of these countries spend anywhere near the 50-60 percent share of R&D that the US devotes to military R&D.
Overall, many high-growth developing countries have already grasped a key point about economic national security that the US is still struggling to grasp. This is the fact that, as noted above, the global competitive marathon increasingly depends on productivity, innovation, and scientific skill, not just command over natural resources or vast pools of untutored “hewers of wood and drawers of water.”
Indeed, US companies that once moved offshore simply because of cheaper inputs, lower taxes, and weaker regulation are now finding that it pays to move their R&D centers offshore as well. This is partly because of the growing availability of engineering skills in places like India, China, and Singapore, but it is also because of the higher barriers to immigration that foreign skilled workers have faced in the wake of 9/11. This policy may or may not have had much impact on terrorism, but by forcing these workers to remain at home, it has certainly had a negative impact on our economic security.
TROUBLED WATERS – PRIVATE R&D
These disturbing trends in federal R&D spending have also been reinforced by recent trends in private sector spending. As we saw earlier, private investment now accounts for more than 70 percent of all US R&D. Unfortunately, because of the current financial crisis and the emerging recession, this funding is drying up even as we speak.
This is especially true for venture capital funds that have relied
heavily on so-called “limited partners” like pension funds and
university endowments. Such investors often manage their portfolios
with fixed allocations – reserving, say, 10 to 20 percent of
investments to “alternative investments,” especially the “D” side of
R&D-intensive ventures. Given the stock market’s steep decline,
this approach to portfolio management and the need to rebalance asset
allocations have virtually dictated a steep decline in private R&D
on how deep this recession is, and how much father stock markets fall, this allocation effect will easily trim private R&D spending by 10-20 percent or more – for a budget that is already, as we’ve seen, under-funded.
At the same time, in uncertain times like these, many private
corporations and investors become less patient. – they become much less
willing to invest in the kind of low-probability/ long-lead time
projects that are the essence of basic research. It is hard to
diversify away such project risks, so private capital markets tend to
demand more immediate, sure-fire payoffs just when “capitalism” is most
in need of real breakthroughs.
In the aggregate, this helps to explain why the primitive “Capitalism R 1.0” version of a market economy -- one that relies exclusively on private investment to fund innovation – is likely to grow much more erratically than one that allows government to play a complementary role, stabilizing support for basic research in good times and bad.
WHAT TO DO
So what should we do about the innovation gap?
¶ First of all, we need to make investing in innovation the national priority that it deserves to be – because future US competitiveness depends on it. In the 21st century, as global competition increases, we cannot simply “Wal-Mart” our way to prosperity.
At a minimum, this implies a significant boost in the current
level of R&D funding, especially in civilian funding, and perhaps increased tax credits and other incentives as well.
Of course, such measures would require increased federal spending, precisely at a time when the federal budget is already severely strained. As we’ve seen, however, the current level of spending is so modest that the US is just “one-half bank bailout” away from the kind of increase in R&D funding that is needed. The alternative of just continuing to stagnate should really be characterized as “eating the seed corn.”
¶ Second, like most enterprises, our country really needs a national technology strategy.
This is not a matter of “industrial policy” or “picking winners,” much less of displacing private funding with government venture capital.
Rather, it is matter of figuring out creative new ways to partner with private capital – including philanthropic donors and university endowments. The aim is to multiply the benefits, by focusing on what the government has always done best – replenishing the “seed-corn” with fundamental longer-term research.
This requires a fresh look at the appropriate role of government in innovation. From this angle, the recent financial crisis is not all bad. Given the disastrous example of excessive reliance on under-regulated markets that we’ve just seen, on the one hand, and the relatively successful long-term track record of government R&D on the other, this is an historic opportunity.
WALKING BACKWARDS FROM SUCCESS
It is especially instructive to walk
backwards from the successes realized by several US examples of
public-private collaboration in “technology hubs” like Silicon Valley,
Boston, and Austin Texas.
In all these cases, private venture capital and entrepreneurs were crucial. But the fact is that federal dollars also played a pivotal role. For decades the federal government generously subsidized basic research in fields like engineering, biology, physics, chemistry, and computer science at premier universities like MIT, Harvard, Stanford, Carnegie Mellon, and the University of Texas.
For example, in the case of Stanford, one of Silicon Valley’s
mainstays, the university has received enormous federal research
subsidies ever since the 1940s. Combined with the Valley’s
highly-competitive venture community, this provided the foundations for
a technology hub that has transformed the world, with innovations like
semiconductors, computer graphics, and wireless communications, and
companies like Intel, Apple, and Google.
In the case of Boston, the National Institute of Health has recently played a key role in helping the community become a technology hub for biotech and pharma research. Boston’s new leadership in this arena is based on enormous NIH funding, channeled to peer-reviewed researchers at regional teaching hospitals. Over time, the steady provision of federal tax dollars has supplied the grist for what has since become a self-sustaining innovation mill. Rather than “crowd out” private funding, federal funding has actually galvanized it, providing a base load of support that allowed a strong technical community – the key to any successful hub -- to take root.
The key issue is whether we can replicate new “Bostons” or “Silicon Valleys” in other geographies, targeted towards priority arenas for innovation like energy, health care, the environment, education, and transportation.
Each of these arenas offers a wide range of subfields. For example, in the energy arena, there’s already path-breaking work under way on clean energy, new electric distribution systems, and new forms of automotive and non-automotive transport. In health care, innovations that lower costs (e.g. EMRs) may be just as important as clinical innovations like new devices, treatments, and compounds.
The point is not to dictate precisely what gets worked on, but to marshal the human resources and infrastructure needed for innovation, build the partnerships with private institutions, and insist on excellence.
In this “incubation” approach, for example, we might ask, what conditions would be needed to yield a period of sustained innovation in the automobile sector? Why not reserve, say, just a few percent of the $25 billion that the federal government has already committed to that sector’s “bailout” for the creation of an “automotive Silicon Valley?” In such a hub, just as in Boston and Austin, a virtuous cycle of innovation and product development would be generated. Pockets of entrepreneurial companies would spawn each other, one after another, competing aggressively and helping to free people and capital from big, slow-moving companies. Universities, communities, and corporations would complement each other’s very different styles and skills.
¶ This renewed emphasis on innovation as a source of national competitive advantage also requires us to beef up our education system, in order to deliver tens of thousands of skilled technicians and engineers. As we’ve seen, there’s also a need for immigration reform that provides greater access to foreign-trained skills – an alternative to the current “scarce visa” system, which basically encourages our competitors to staff up their own technology-based industries. In this case, we’re not just eating the seed corn; we’re giving it away.
Finally, the other crucial requirement of an innovation revival is a national culture that reminds young people of their innovation heritage, and encourages them to become engineers, designers, and scientists, rather than just lawyers, accountants, and bankers -- whose preferred form of ingenuity, in Thornstein Veblen’s words, has always been “clever chicanery, or the thwarting thereof.” As we’ve argued, now more than ever, we need to curtail all this chicanery and return to the much better American tradition, innovation on the real side of the economy.
(c) SubmergingMarkets, 2008
Jim Manzi was Chairman of Lotus Development Corporation, and is now Chairman of Thermo Fisher Corporation, a $10 billion life sciences company based in Waltham Massachusetts.
Saturday, October 11, 2008
HANK PAULSON'S OCTOBER REVOLUTION Why This Republican X-Banker Has Decided to (Partially) Socialize Our Entire Banking System James S. Henry
"We have made changes, Sire. Yes, it is true, we have made changes. But we have made them at the right time. And the right time is, when there is no other choice."
-- Conservative adviser to King Edward VII, explaining his support for liberal reforms
We may have just reached a critical turning point in American political economy -- not only in our efforts to overcome the burgeoning global banking crisis, but also to overcome the pernicious influence of free-market fundamentalism, which has dominated US economic policy for the last 30 years.
Ironically enough, the person who deserves more credit than anyone else for helping us to reach these goals is our current Treasury Secretary, a lifelong die-hard Republican and former Wall Street king-pin.
Last night, a few hours after the US stock market closed, the Bush Administration, embodied in Henry M. Paulson,Jr., announced that in order to stem the continuing turmoil in capital markets, in conjunction with other G-7 countries, the US federal government will begin "as soon as we can" to use taxpayer money to buy preferred equity in private financial institutions, especially banks.
Depending on how it is implemented, this could very well amount to a partial nationalization of the entire US banking system by the US Government. Are you paying attention here, Hugo, Fidel, and Evo?
This marks a very sharp U turn in recent US policy. Indeed, just two weeks ago, in their September 23rd testimony before Congress, Paulson and Federal Reserve Chair Ben Bernanke dismissed such equity investments as a "losing strategy," compared to their preferred scheme, a government-run "reverse auction" to buy up to $700 billion of "toxic" bank assets.
This policy U-turn was not due to sudden new insights generated by careful academic analysis or some precise economic model.
It feels more like a Hail-Mary pass, coming at the end of one of the most disastrous weekly stock market performances in US and global history.
That, in turn, was preceded by ten exhausting days of political goat-rodeo and Congressional negotiations over the infamous "$700 billion bailout," on top of the preceding six exhausting months of more or less ad hoc, increasingly expensive but largely unsuccessful one-off interventions in money markets and the banking system by the US Treasury, the Federal Reserve, and a myriad other US bank regulators.
Meanwhile, there has been an even more quirky set of poorly-coordinated improvisational remedies administered by diverse regulators in the UK, Germany, France, Iceland, and Belgium.
At the end of all this, fear, uncertainty, and doubt (FUD) have continued to spread across global capital markets, as policymakers stumble into each other, national banking systems compete for deposits, the US Treasury becomes (ironically) a huge depository for safe-haven flight capital, and no one manages to get ahead of the crisis.
If the FUD continued to spread, and global credit remained on lock-down, the forthcoming global recession -- already likely to plunge real growth in Europe and the US to zero or less next year, China to 6 - 8 percent or less, and the rest of the developing world to 4-6 percent -- would become dire indeed.
So one answer to the riddle of Paulson's "sudden conversion" is that he simply had no alternative. Given that ad hoc bailouts, coordinated interest rate cuts, increased deposit insurance, the extension of government insurance and liquidity to money market funds, the commercial paper market, on top of the takeovers of AIG and Fannie/ Freddie, had not done the job, nationaliziation -- really internationalization, since global banks are involved, and other countries will presumably be asked to contribute -- is one of the few arrows left in his quiver.
This will hardly be the first US experience with quasi-nationalization. Indeed, on September 16, the Federal Reserve had effectively "nationalized" the giant insurance company AIG, acquiring 80 percent of its equity in exchange for an $85 billion loan. And on September 7, the US Government announced that it had formally taken over Fannie Mae and Freddie Mac, the world's largest players in the "secondary" mortgage market, with more than $1.6 trillion of assets. All told, these are probably the largest nationalizations anywhere in human history.
Way back in the 1930s and 1940s, the US Reconstruction Finance Corporation seized and recapitalized many banks. The FDIC has also done this many times since then.
European governments have even longer histories of direct intervention in banking markets. And several of them moved almost too quickly in the last year to nationalize particular banks -- for example, the UK's Northern Rock in February 2008 and Fortis in September 2008.
Of course, most of these recent cases have involved failing institutions, where the government was a "lender of last resort." As discussed below, Paulson's plan is rather different.
Even farther back, in the early 19th century, states like Virginia and Pennsylvania often invested directly in state-chartered banks to set them up and keep them going. Those were not especially happy experiences with government ownership.
But this is hardly a great time for champions of private capital markets to be quibbling about the efficiency costs of government intervention -- private markets in the US alone have just lost $7 trillion of market cap in the last year, including $3 trillion in the last 3 weeks. And the global "opportunity cost" of the crisis is probably at least twice this high.
A GLOBAL RECOVERY FUND?
If done right, Paulson's PIP (Public Investment Program) will be much broader, more proactive and more innovative than previous bank nationalizations.
For example, one idea would be to establish a "Global Recovery Fund," permitting fresh private capital, "sovereign wealth funds" like those in Norway and the UAE, and European, Latin and Asian countries that have a clear stake in restoring the world's financial sector to health to invest alongside the US Treasury.
Even, Heaven help us, the IMF and the World Bank's IFC might participate in such a fund. They have run out of developing country crises to solve, are looking for a new role, and have $billions in untapped credit lines.
Such an approach would help to share the heavy burden placed on US taxpayers, and make this program more politically palatable than the TARP bailout proved to be.
A global fund would also help to diversify investment risks across many more countries and banks.
Indeed, the USG and its new partners might even become lenders of far-from-last resort, clearing the way for threatened but essentially-healthy institutions to survive the financial contagion, raise much more private capital as well, and, most important, turn each and every new $1 of equity into $10 to $15 of new lending.
If the fund is successful in reviving the world's financial system, and restoring banks to financial health, taxpayers and investors will no doubt all be paid back handsomely. But the most important benefits may be the "hidden" ones -- the catastrophic losses that would be avoided by preventing further chaos and market decline.
This is very different from Paulson's original TARP buy-back scheme, which promised to boost bank equity informally by way of overpaying for toxic assets with highly-uncertain values.
Ironically, that approach just rewards those companies with the very worst portfolios and lending practices, while enabling much less increased lending.
Indeed, TARP's only comparative advantage seems to have been that by avoiding direct government investment in the private sector, it did not violate any red lines of so-called free-market conservatives.
In hindsight, however, given TARP's birth pains, plus the fact that the market value of all US publicly-traded stocks fell from $12.9 trillion on September 19 to $9.2 trillion in the three weeks after Paulson Plan I was announced.
So respecting this neoliberal ideological taboo may well have just cost US investors -- most of whom are taxpayers -- at least $1 to $2 trillion of market value that might have been saved with an immediate recapitalization plan.
With that much extra dough, we could almost afford to wage another Iraq-scale war somewhere.
The PIP program faces many challenges. It needs careful guidelines about how to value investments, which banks will be eligible, and how they will be incented to participate. There needs to be controls the propensity of Treasury officials to have "revolving door" relationships with the companies they are investing in.
It is also vital to focus on the program's central objective -- a temporary investment to stabilize the financial system, returning the investment (hopefully with gains) to the Treasury as soon as possible.
The US Treasury also needs to decide what corporate rights we should get for our money.
For example, Mr. Warren Buffett, everyone's favorite wealthy investor these days, would probably demand protections against non-dilution and excessive dividends to other shareholders, and perhaps voting rights as well, if he were the investor. If taxpayers are investing and taking all this risk, why is Warren's money any more deserving of such rights than ours?
None of these issues are insurmountable. Furthermore, purchasing equity in established, publicly-traded institutions will certainly be a whole lot easier than setting up brand new, complex "reverse auction" markets for previously untraded mortgage-backed securities, much less insurance on them.
In any case, as we'll examine in Part II of this article, given the incredibly shaky structure of the global banking system's balance sheet, especially in the US and Europe, at this point Hank Paulson's public equity investment plan is really the US Treasury's only option for putting our banking system back on its feet.
So viva Comrade Hank! Y Viva la Revolucion!
But investors, workers, home owners, students, beware: it still pays to be conservative here, despite Hank's Revolution.
Because even if the government invest heavily in all these banks, no one is still quite sure what all those $trillions of asset-backed securities on and off their balance sheets are worth.
We may not find out until the housing market touches bottom and there are comprehensive audits of major financial institutions and their hedge fund buddies.
So keep at least some of your powder dry and hang on to your hats -- the ride will continue next week.
Wednesday, September 24, 2008
BUSH SPEAKS: "HOW DID WE EVER GET IN THIS MESS? WHERE HAVE I BEEN?" James S. Henry
Last night on national television, Comrade Bush presented his own miniature 14-minute "Cliff Notes" version of the roots of the current US financial crisis, and a heart-rending appeal for the most generous act to date of his Administration, the $700 billion blank-check Wall Street bailout.
By now the man has established a bit of a pattern -- customarily trying to scare us all into granting him unlimited powers, while arguing that there is simply no alternative to whatever bitter pill he happens to be pushing at the moment.
You are of course free to believe him if you like. Hundreds do.
These include things like, at a minimum, (1) equity investment and warrants for taxpayers, to provide some upside returns in proportion to the risks we are taking on any purchases of bank assets; (2) stronger oversight; (3) more assistance for the millions of Americans who are experiencing home foreclosures; (4) compensation ceilings, clawbacks, and stiff progressive tax rates on incomes over $1 million and estates over $10 million, to offset the cost of all this; (5) a Financial Products Safety Commission; (6) a new Treasury-backed competitive insurance market for mortgage securities, available to banks and homeowners; (7) expanded FDIC reserve fund rather than buy "toxic" bank securities up now, set up an -- since all the "I-banks" are commercial banks now, anyway; (8) a new installment of the 1932 Pecora Commission, complete with subpoena power, to investigate the origins of the crisis and hold people accountable.
(For more details, here is the testimony that Dr. Brent Blackwelder, Friends of the Earth, and I submitted to Rep. Frank's House Financial Services Committee yesterday: BAILOUT.pdf)
Even more important, the President's central claim that there is no alternative to this bitter pill is a triple whopper with cheese.
As the IMF -- not our favorite institution, but it does know a thing or two about recapitalizing broken banking sectors -- has suggested just this week, long-term "swaps" of mortgage-backed securities for government bonds could be used to clean up the banks' balance sheets while completely sparing taxpayers the risks of a huge loss on the $billions of toxic assets we'll soon be owning.
There are also numerous other approaches to broken-banking sector restructuring that have been employed by governments all over the planet in more than 124 banking sector crises since 1970 -- for example, in Chile, Korea, Germany, Mexico, and Japan.
Doesn't anyone else find it odd that none of this expertise is being put to use?
Or that, with losses on complex derivative and structured securities at the core of this debacle, and thousands of "quants" from MIT and Wharton on Wall Street, we cannot design some simple security vehicles to help taxpayers reduce their personal or collective exposure to its potential costs?
Perhaps Bush & Co. are not familiar with the IMF or the World Bank/ IFC's "Capital Markets Group." Perhaps Secretary Paulson never bothered to understand the first thing about derivatives and options during his 32 years at Goldman Sachs.
Their staffs are not especially busy at the moment -- indeed, 15 percent of the IMF's professionals are being laid off, so they may have some time to help out.
We've been assured by the Bush Administration, however, that the IMF's assistance is not really needed at this point.
"What are we," Bush asks, "Some sort of two-bit corrupt, debt-ridden plutocracy that can't manage its own affairs?"
Indeed, the President, Secretary Paulson, and a weird new assortment of bottom-feeding Wall Street investors (Omaha's Warren Buffet, Tokyo's Nomura Holdings and Mitsubishi UJF), and, of course, those who are still left on Wall Street itself are in a white heat to get this deal done, and are trying to create a stampede.
They are also clearly not interested in improving the bailout. They just want our money -- and a loosey-goosey, behind-closed-doors process for distributing it that hasn't even been designed yet.
Unlike US taxpayers, Buffet, who is reportedly investing $5 billion in Goldman Sachs, was saavy enough to get preferred shares and warrants for his money -- worth up to 8 percent of the premier bank's share.
At that rate, just think how much Wall Street real estate our $700 billion would buy -- if only Paulson and Bernanke and the US Congress would follow in Buffet's footsteps and insist on some equity and warrants in exchange for a bailout.
Meanwhile, Bush has the temerity to intermeddle (once again) with the orderly conduct of a US Presidential election, by inviting the two leading Presidential candidates to the White House just to help him close the deal with Congress. (Ralph Nader and Bob Barr are reportedly already camped out in the White House basement.)
As if Secretary Paulson and Chairman Bernanke were not already the world's consummate sales team!
Of course both Obama and McCain will accept the President's hospitality -- they have no choice.
So both have now been roped into making this deal happen.
Alas, it probably will -- minus almost all of the possible improvements noted above. The largely symbolic CEO comp limit is probably the only exception
To those to whom much has been given, even more will be given.
We do have one consolation, however, as we prepare to pay the check for this lousy meal. We've located a different version of the history of this crisis that is more accurate -- and more entertaining -- in this must-see video:
Tuesday, September 23, 2008
SO, FORREST, WHAT DO WE DO NOW? Ten Steps to Fix the Paulson Plan and Solve the US Debt Crisis JS Henry and Brent Blackwelder
The US Congress is busy working hard on US Treasury Secretary Henry M. Paulson Jr.'s $700 billion TARP bailout plan -- at least everyone except Alabama's Rep. Spencer Bachus, the ranking Republican on the House Financial Services Committee, who has spent much of the day explaing why a senior official in his position has the time, much less the ethical license, to be making scores of options trades during office hours.
While we have every confidence that Rep. Bachus and his peers will provide masterful oversight of the Secretary's proposal, it is understandable that with less than six weeks left to the November election, and Congress set to adjourn on Sept. 29, we appreciate that they may have more important things to worry about than the greatest US financial crisis since the Great Depression.
So it is time to help them out. Given the widespread dissatisfaction -- indeed, revulsion -- at Paulson's initial request for a $700 billion blank check -- on top of the other $500 - $700 billion that the Treasury/ FDIC and the Federal Reserve have already committed to Fannie/ Freddie, AIG, Bear Stearns, and other banks this year -- it is clear that revisions are needed. But time is short -- not just because of election imperatives, but because global financial markets are on pins and needles, waiting for a clear solution.
Any time there is this kind of sea-changing economic event, it tends to surface every interest group's Christmas wish list of long-delayed "essential reforms."
In this situation, indeed, the crisis has brought forth everything from proposals for "nationalizing the banks" and new regulatory agencies to "clawbacks" in executive severance plans and income tax reform. There are also a substantial number of people who are concerned about the implications of the initial Paulson proposal for constitutional democracy -- some have called it as nothing less than an "economc coup d'etat" by "Commandate Paulson," because of all the unreviewable authority it would have vested in the Secretary and his minions.
Given that Congress is moving at the speed of light, we need to "tier" these proposals according to their importance. There are also a few more innovative ones that deserve immediate attention. Here's our own "Top Ten Improvements" wish list.
1. Equity “Upside” and Voting Power.
In return for the undeniable new risks that US taxpayers are taking on, and the poor management track record of leading Wall Street institutions, it is reasonable to insist that they receive an “upside” on the value of participating financial institutions (FIs) themselves as well as on the potential increased value of acquired mortgage-backed assets. This proposal commands widespread support in this panel.
Technically, this could be accomplished by demanding preferred shares (with anti-dilution provisions) from any financial institutions (FIs) that receive assistance, as was routinely done by Bank of Japan in exchange for financial assistance during the Japanese bank restructuring of the 1990s, and by the Chilean government during the February 1983 bank nationalization.
Warrants might also be used, as was done in the case of the 1979 $1.2 billion Treasury loan guarantee to Chrysler. (According to Sen. Bradley, the Federal Government eventually made money on those warrants.) We believe that while warrants are easier to implement, it is vital to insist on actually equity (including voting power). This will provide the Treasury with much more direct influence over management behavior, will be easier to value, and will also be easier to explain to the public than warrants.
2. Clawback Provisions for Executive Severance Pay.
The basic principle here is that for senior FI executives, there should be accountability for some time period even after they leave office – at a minimum, any future compensation or severance that they receive should be subject to stiff taxes or repossession in bankruptcy court. Insisting on compliance with this standard should be a condition for participation in the bailout.
3. Share the Pain.
A. Emergency Taxes.
Since this very costly bailout package may severely limit the ability of the Federal Government to afford vital programs like health insurance reform and alternative energy, it is important that we deal now with the substantial “tax justice” implications of the bailout.
One way to do this would be to start treating this as the national emergency that it really is, and help ordinary taxpayers pay for it by: (1) eliminating the carried-interest benefits for hedge fund managers; (2) cracking down on offshore havens – no FIs should be permitted to establish subs or place SPVs in them; (3) imposing at least a temporary increased income tax rate on all people with incomes above $1 million and on all estates above $10 million.
B. Compulsory Write-Down/ Debt Reduction of Residential Mortgages.
Given the failure of this summer’s relief packages for ordinary mortgage holders to have much impact, and the fact that foreclosures are still increasing (to a record 100,000+ per month, and that housing prices are still falling in a majority of key markets, this is an another essential measure. The debt restructuring should be implemented quickly, affect large numbers of people, and be inversely proportional to mortgage size. It might also be means –tested.
Such a measure would not only provide equitable relief to millions of would-be homeowners; it would also help to kick-start a US economy recovery.
4. Financial Products Safety Commission.
This would review and certify the quality of all financial products offered to the general public. Products like zero-down payment mortgages would require special labeling, and might not qualify for government incentives like interest deductibility, access to the government insurance window, and so forth.
5. A New US Treasury-Created Market for MBS Insurance.
A novel idea suggested by our good friend Prof. Lawrence Kotlikoff of Boston University is that the US Treasury might be able to use current authority to offer ABX-like insurance at a fixed price per tranche to institutions that hold MBSs. According to Professors Kotlikoff and Merlin, if such a government-backed insurance market were in place, backed by a significant reserve against losses, it might even obviate the need for the entire $700 billion, while creating a market-based workout alternative.
This could be combined with #1, if FIs were allowed to pay for the insurance with equity or warrants. This would also have the benefit of helping to recapitalize troubled FIs.
6. New “Pecora Commission” (ala 1932): a congressional committee with subponae power to investigate the root causes of this crisis and recommend further steps.
Saturday, September 20, 2008
SOCIALISM FOR BANKERS, SAVAGE CAPITALISM FOR EVERYONE ELSE? Bailout Jeopardizes the Entire Progressive Agenda James S. Henry
Ladies and gentlemen: pardon my intemperance, but it is high time for some moral outrage -- and a little good old-fashioned class warfare as well, in the sense of a return to seriously-progressive taxation and equity returns for public financing.
After all, as this week's proposed record-setting Wall Street bailout with taxpayer money demonstrates once again, those in charge of running this country have no problem whatsoever waging "class warfare" against the rest of us -- the middle classes, workers and the poor -- whenever it suits their interests.
At a time when millions of Americans are facing bankruptcy and the risk of losing their homes without any help whatsoever from Washington DC, the CEOs and speculators who created this mess, and the top 1 percent of households that owns at least 34 percent of financial stocks, and the top 10 percent that owns 85 percent of them, have teamed up with their "bipartisan" cronies in Congress, the US Treasury and the White House to stick us with the bill, plus all of the risk, plus none of the upside.
Upon close inspection, the Treasury's proposal is nothing more than a bum's rush for unlimited power over hundreds of $billions, to be distributed at Secretary Paulson's discretion behind closed doors and without adequate Congressional oversight.
This time they have gone too far.
As discussed below, the cost of this bailout could easily jeopardize our ability to pay for the entire economic reform program that millions of ordinary citizens across both major parties have been demanding.
Some kind of bailout may indeed be needed from the standpoint of managing the so-called "systemic risk" to our financial system.
However, as discussed below, the Paulson plan does not really tackle the real problem head on. Thsi is the fact that many financial institutions, including hundreds of banks, are undercapitalized, and need more equity per dollar of debt, not just fewer bad assets.
To provide that, we may well want to mandate debt restructurings and debt swaps, or provide more equity capital .
If private markets can't deliver and we need to inject public capital into financial services companies on a temporary basis, so be it. But it should only be in return for equity returns that compensate the pubilc for the huge risks that it is taking.
Call that "socialism" if you wish -- I think we are already well beyond that point -- sort of like Chilean economists became in 1983, when the entire private banking sector collapsed and was nationalized -- successfully -- by the heretofore "Los Chicago Boys."
To me, public equity investment, in combination with increased progressive taxation, should be viewed as just one possible way to get these companies the equity they need, while providing fair compensation to the suppliers of capital and participation in any "upside," if there is one.
Absent such measures, progressives certainly have much less reason to support this plan. After all, the increased public debt burdens that it would impose are so large that they could easily jeopardize our ability to pay for the entire economic reform program that millions of ordinary citizens (across both major parties) have been demanding.
From this angle, the Paulson program, in effect, is a cleverly-designed program to "nationalize" hundreds of billions of risky, lousy assets of private financial institutions, without acquiring any public stake in the private institutions themselves, and without raising any tax revenue from the class of people who not only created this mess, but would now like to be bailed out.
Any mega-bailout should come at a high price for those who made it necessary.
In particular, we must make sure that the butcher's bill is paid by the tiny elite that was responsible for creating this mess in the first place.
This is not about retribution. It is about insuring taxpayers are truly rewarded for the risks that they are taking -- isn't that the capitalist way? And it is also about making sure that this kind of thing never happens again.
After all, the real tragedy of this bailout is its opportunity cost. Consider a well-managed $1 trillion "matching" investment in strategic growth sectors like energy and health....If we really wanted to insure our competitive health, we would not be investing $1 trillion in lousy bank portolios generated by the chicanery-prone financial services sector.
CAPITALISTS AT THE TROUGH
This estimate is consistent with the $700 billion ("at any point in time") that President Bush and Treasury Secretary Hank Paulson are requesting from Congress this week to fund their virtually-unfettered ("unreviewable by any court") new "Troubled Asset Relief Program." (TARP)
The sheer scale of Paulson's proposal implies that federal authorities plan to acquire at least $3 trillion of mortgage-backed securities, derivatives, and other distressed assets from private firms -- on top of Fannie/ Freddie Mac's $5.3 trillion mortgage securities portfolio. How the Fed and the Treasury actually propose to determine the fair market value of all these untrade-able assets is anyone's guess. But since 40 percent derive from the exuberant, fraud-prone days of 2006-7, they will probably all be subject to steep (60-90 percent) discounts from book value.
That's consistent with the 78 percent "haircut" that Merrill Lynch took on the value of its entire mortgage-backed securities portfolio earlier this month -- actually, more like a 94.6% haircut, the portion that it received in cash.
This implies, by the way, that if the Federal Government were required to "mark to market" their $29 billion March 2008 investment in Bear Stearns' securities, it would now have a cash value of just $1.6 billion. Not a very hopeful sign from a taxpayer's standpoint.
Paulson's latest proposal dictates another sharp increase in the federal debt limit, to $11.313 trillion. This limit stood at just $5.8 trillion when Bush took office in 2001. By October 2007 it stood at $9.8 trillion. Then it jumped again to $10.6 trillion in July 2008, during in the Fannie/Freddie meltdown. As of March 2008, the actual amount of Federal debt outstanding was $9.82, just six months behind the limit and gaining.
All this new TARP debt will be on top of $200 billion of new debt that was issued to buy Fannie/Freddie's preferred stock, plus the assumed risk for their $1.7 trillion of debt and $3.1 trillion of agency mortgage-backed securities.
It is also in addition to the $85 billion 2-year credit line that Federal Reserve just extended to AIG, the $29 billion "non-recourse" loan provided for the Bear Stearns deal noted above; $63 billion of similar Federal Reserve lending to banks this year; $180 billion of newly-available Federal Reserve "reciprocal currency swap lines:" $5 billion of other emergency Treasury buybacks of mortgage-backed securities; $12 billion of Treasury-funded FDIC losses on commercial bank failures this year (including IndyMac's record failure in July); perhaps another $455 billion of Federal Reserve loans already collateralized by very risky bank assets; and the FDIC's request for up to $400 billion of Treasury-backed borrowings to handle the many new bank failures yet to come.
There is also the record $486+ billion budget deficit (net of $180 billion borrowed this year from Social Security trust fund) that the Bush Administration has compiled for 2008/09, drivem in part by the continued $12-$15 billion per month cost of the Iraq and Afghan Wars and the impact of the deepening recession on tax revenues. Longer term, there is also the projected $1.7 trillion to $2.7 trillion "long run" cost of those wars (through 2017).
All told, then, we're talking about borrowing at least another $1-1.4 trillion of federal debt to finance a record level of lousy banking.
COMPARED TO WHAT?
By comparison, Detroit's latest request for a mere $25 billion bailout looks miserly. And if we were in Vienna, we would say, "We wish we could play it on the piano!"
Compared to other bailouts, this is by far the largest ever.
For example, the total amount of debt relief provided to all Third World countries by the World Bank/IMF, export credit agencies, and foreign governments from 1970 to 2006 totaled just $334 billion ($2008), about 8 percent of all the loans. (Henry, 2007).
The savings and loan bailout in the late 1980s cost just $170 billion ($2008).
And the FDIC's 1984 bailout of Continental Illiinois, the largest bank failure up to this year, was (in $2008) just $8 billion (eventually reduced to $1.6 billion by asset recoveries).
Meanwhile, compared with other countries that are well on their way to building forward-looking "sovereign wealth funds" to make strategic investments all over the world, the US seems to be on a drive to create this introverted "sovereign toxic debt dump."
No one has a very precise idea of how much all this will cost, not only because many of the securities are complex and thinly traded, but also because their value depends to a great extent on the future of the US housing market. Housing prices have already fallen by 20-32 percent in the top 20 markets since mid-2006, and they continue to fall in 11 out of 20 major markets, especially Florida, southern California, and Arizona, where the roller-coaster has been the most steep.
At current T-bond rates (2-4 percent for 2-10 year bonds, the most likely maturities), near-term cash cost of this year's bailu is likely to be an extra $40 to $60 billion a year in interest payments alone.
Furthermore, since the borrowed funds will be invested in high-risk assets, the most important potential costs involve capital risk. There's a good chance that, as in the case of Bear Stearns, we'll ultimately get much less than $.50 for each $1 borrowed and invested. For example, Fannie and Freddie alone could easily be sitting on $500 billion of losses (=$2 trillion/$5.3 trillion* 50% default*50% asset recovery).
This could easily make the long-run cost of this bailout to taxpayers at least $150 billion a year.
No wonder traders on the floor of the New York Stock Exchange reportedly broke out singing "the Internationale" when they heard about the bailout.
But the direct financial costs of the bailout are only the beginning....
HIJACKING THE FUTURE
Last week's events produced terabytes of erudite discussion by an army of Wall Street journalists, prophets and pundits about short-selling rules, "covered bonds," and the structure of the financial services.
This is absolutely par for the course, as modern financial crisis journalism is concerned -- the "story" is always told mainly from the standpoint of what's in it for the industry, the banks, the regulators, and the investors.
For the 90 percent of Americans who own no money-market funds, and less than 15 percent of all stocks and bonds, however, this bailout means just one thing.
All of the money has just been spent. And it has not been spent on you.
For example, unless we demand an increase in taxes on the rich, big banks, and big corporations, as well as some public equity in exchange for the use of all this money, we can expect that the long-term costs of this bailout will "crowd out" almost all of the $140 to $160 billion of new federal programs that Barack Obama proposed. It will certainly make it impossible for Obama to finance his programs without either borrowing even more heavily, or going well beyond the tax increases (on oil companies and the upper middle classes) that he has proposed.
There will be no additional funding for pre-school education, child care, or college tuition.
There will be no additional funding for investments in energy conservation, wind, or solar power.
There will be no additional investments in national infrastructure (e.g., the reconstruction of our aging roads, highways, and bridges to "somewhere.")
Highway privatization and toll roads, here we come.
There will be no money to bail out the millions of Americans who are on the brink of losing their homes.
The supply of housing loans and other credit will remain tight, despite the bailout.
Indeed, if the economic elite has its way, the long-sought dream of "a home for every middle-class American family" may be abandoned as a goal of government policy.
Meanwhile, the government-sponsored consolidation of the financial services industry will make financial services more profitable than ever.
This is good news for the "owners of the means of finance." For the rest of us, it means steeper fees and rates. And if we fail to keep up with the new charges, we'll face the rough justice delivered by the latest bankruptcy "reform," which was rammed through the Congress in 2005 with support from many top Democrats.
Indeed, ironically enough, this latest bank bailout may even increase the financial pressure to privatize these comparatively successful government programs.
There will be no extra money to house our thousands of new homeless people, relieve poverty, rebuild New Orleans, or support immigration reform.
There will be no additional funds for national parks.
Indeed, we might as well start by privatizing our national and state parks, and drilling for oil and gas in the Arctic National Wildlife Refuge, Yosemite, the Grand Canyon, and right off the Santa Barbara coast. We're going to need those federal lease royalties. (Perhaps the oil barons will lend us an advance.)
There will be no funds available for increased homeland security.
There will certainly be no "middle-class" tax cut. Absent a progressive tax reform, the only "cut" the middle class is going to receive is another sharp reduction in living standards.
All told, the Bush/Paulson "permissive banking/ massive bailout" model beats even the old 1980s vintage Reagan formula, which tried to force government down-sizing with huge tax cuts.
Contrary to the sales pitch, those cuts never produced any incremental tax revenues, let alone any significant down-sizing. It has simply proved too easy for the federal government to borrow. And "conservatives" can always find wars, farm subsidies, defense contractors, and "bridges to nowhere" to spend the money on, just as fast as liberals.
Lately, however, it appears that US debt levels may indeed be reaching the point where they could impose a limit on increased spending. Given the sheer size of the new federal debt obligations, foreign creditors,who have recently been supplying more than half of new Federal borrowing, have been muttering about taking their lending elsewhere. And outside the financial services industry, Main Street companies are concerned being "crowded out" by record federal borrowing.
THE ALTERNATIVE -- THE "GET REAL" NEW DEAL
To make sure that real economic reform is still feasible, we need to demand a "Get Real/ New Deal" from Congress right now.
At a minimum, this Get Real/New Deal package should consider measures like:
(1) The restoration of stiff progressive income and estate taxes on the top 1 percent of the population (with net incomes over $500,000 a year and estates over $5 million) -- especially on excessive CEO and hedge fund manager compensation;
(2) Much more aggressive enforcement and tougher penalties against big-ticket corporate and individual tax dodgers;
(3) Tougher regulation of financial institutions -- possibly by a new agency that, unlike the US Federal Reserve, the SEC, and the US Treasury, is not "captive" to the industry;
(4) A crackdown on the offshore havens that have been used by leading banks, corporations, and hedge funds to circumvent our securities and tax laws;
(5) The immediate revision of the punitive bankruptcy law that Congress enacted in 2005 at the behest of this now-bankrupt elite; and
(6) While we are at it, stiff "pro-green" luxury taxes on mega-mansions, private jets, Land Rovers, yachts, and all other energy-inefficient upscale toys.
We also need (7) a National Commission to investigate the root causes of this financial crisis from top to bottom, and actually (unlike the hapless, ineffectual 9/11 Commission) hold people accountable.
Finaily, if the pubilc is going to provide so much of the risk capital for this restructuring, we should demand (8) public equity in the private financial institutions that receive so much of our help.
This will permit taxpayers to share in the upside of this restructuring, rather than just the downside risks.
Along the way, this will require that we explain to Secretary Paulson that this country is not Goldman Sachs. Even after 8 years of President Bush, this is still a democracy.
Secretary Paulson is not going to be given unfettered discretion to hand out closet "liquidity injections" to his buddies on the street -- no matter how worthy they are.
This will be essential, if the Federal Government is to be able to afford key reforms like health insurance, clean energy, and investments in education.
These may not matter very much to Wall Street executives, financial analysts, Treasury and Federal Reserve executives, or the more than 120-130 Members of Congress and 40-45 US Senators who earn more than $1 million a year -- and are already covered by a generous "national health care" package of their own design.
But these are the key "systemic risks" that ordinary Americans face.
These reforms may sound ambitious. So is the bailout. And the reforms that we are discussing are only fair.
After all, we the American people have recently been the very model of forgiveness and understanding.
We have tolerated and footed the bill for stolen elections, highly-preventable terrorist attacks, gross mismanagement of "natural" disasters, prolonged, poorly conceived, costly wars, rampant high-level corruption, pervasive violations of the US Constitution, and the systematic looting of the Treasury by politically-connected defense contractors, oil companies, oligopolistic cable TV and telecommunications firms, hedge fund operators, big-ticket tax evaders, and our top classes in general.
Does "class" still matter in America? You betcha -- perhaps more than ever. But enough is enough. Call your Congressperson now. Demand a"Get Real/ New Deal" qualifier to the bailout package before it is too late. We deserve to get much more for our money. So do our kids.
(c) SubmergingMarkets, 2008
Saturday, July 26, 2008
"MAKE FREDDIE AND FANNIE GO GREEN!" Attach Green Strings to Those $Billions of Bailout Greenbacks! Brent Blackwelder and James S. Henry
With Congress about to "lend" at least $300 billion to Fannie Mae and Freddie Mac, the nation's two giant mortgage lenders, shouldn't we at least insist in getting some lending policies that help promote energy-efficient new housing for all this money?
For the full article, go here.
(Note: Brent Blackwelder is President of Friends of the Earth. He is not only a committed environmentalist but a straight arrow. Unlike the others on this page, he has never pocketed $millions from a $9 billion corporate earnings overstatement or mismanaged a gigantic corporation, let alone defended white-collar criminals, barred FBI agents from sharing intellligence with the CIA and DOD, or helped to shield former senior CIA and NSA officials from responsibility for 9/11.)
Tuesday, July 15, 2008
"DON'T LOOK DOWN!" The Emerging US Debt Crisis -- From Wall Street To Main Street By Way of Washington James S. Henry
As George Soros said this week, this may be "most serious financial crisis of our lifetimes" -- the worst since the S&L bailouts of the 1980s, and quite possibly since the Great Depression.
Of course the apocalyptic, self-hypnotic Mr. Soros has been over-predicting the penultimate "crisis of global capitalism" since at least 1987, when his first book, "The Alchemy of Finance," appeared. He also has a long history of profiting from short-side bets and Black Fridays.
However, the potential scope of this current US debt crisis is indeed enormous. The ultimate cost to taxpayers of the associated bailouts will almost certainly make the $29 billion March 2008 Bear Stearns bailout look like batting practice.
We already knew that the American economy was suffering from soaring energy and food prices, rising unemployment, and falling house prices, with several mid-sized banks at risk of failure. At least 2.5 million would-be homeowners are headed for mortgage foreclosures in 2008, credit card, auto loan, student loan, and home equity loan repayment problems have soared, and millions of ordinary citizens are discovering the high costs of not being "too big to fail."
Since early July, however, the continuing collapse of the housing market, on top of mounting debt problems in other sectors, has helped to produce a growing loss of confidence in many larger financial institutions, and bouts of near-panic and wild volatility on Wall Street.
Indeed, the crisis may now pose a "contagion" risk to a wide variety of companies with household names, like GM, Ford, and Chrysler, Citigroup, BankAmerica, Wachovia, Wells Fargo, Washington Mutual, investment banks like Lehman Brothers and UBS, airlines like US Air, Delta, and American Airlines, and debt-ridden hotel chains like Hilton.
The crisis may also threaten the solvency -- refinancing ability -- of Fannie Mae and Freddie Mac, two gargantuan "government-sponsored enterprises" (GSEs) that have long been treated by investors as virtually risk-free, despite having private shareholders, private sources of capital, and no official government guarantee for their enormous debt.
Most Americans have probably never heard of these two giants. But they are at the very heart of the $21 trillion (capital) US housing sector. Originally there was just Fannie Mae, created in 1938 as a government-owned monopoly to add liquidity to housing and help realize the peculiar American desideratum of "every man a king in his own castle" -- as if renting castles or otherwise sharing their use might not sometimes be a wiser resource of national resources.
Of course this social objective soon proved to be extremely popular with a vast coterie of private interest groups -- including land owners, developers, builders, building supply companies, real estate agents, architects and engineers, landscapers, title companies, insurers, and real estate law firms, not to mention the private banks, credit unions, and savings and loan associations that usually provided the first line of lending for home mortgages, as well as the Wall Street investment banks that stood to take a nice cut out of assembling the private capital required for this venture.
In principal, the US Government might have simply declared that in order to achieve the noble goal of universal home ownership, it would provide direct government loans to homeowners, or, even better, just subsidize new house purchase with direct grants or tax credits, leaving the rest of the program to private housing markets to sort out. But this simple, direct approach smacked of "socialism," which every interest group, lobbyist, and Congressmen in Washington instinctively just new to be hopelessly inefficient.
The elegant alternative designed and pursued with the support of all these various interests was to have the US Government remain in the background as much as possible. Except for low-income people and veterans, which the private interest groups didn't much care about servicing anyway, it would channel most of its subsidies for mass home ownership through two vehicles -- providing (2) a tax deduction for "home mortgage interest," and (2) creating a "secondary market" for mortgages, where banks could easily sell off loans they had issued, in the interests of encourage them to issue still more.
WAR CRISIS #1
Forty years later, in 1968, a fateful Presidential election year, Lyndon Johnson faced a budget deficit because of the high costs of the increasingly-unpopular Vietnam War. Rather than raise taxes and stoke this opposition, he decided to use "off-balance sheet" gimmicks to reduce the US Government's deficit.
One of these was to half-privatize Fannie Mae, turning over ownership to private shareholders, hiring a coterie of very well-paid managers whose remuneration depended in large part on FNM's stock price, and sourcing more than 98 percent of its capital by floating bonds to non-USG investors.
At the same time, since it was just too much of a blatant goody-grab to privatize Fannie Mae as a monopoly, Johnson and the US Congress also created Freddie Mac to compete with it. Most economists usually don't expect to see much "competition" from an unregulated private duopoly like this one -- indeed, quite the opposite. But it must have seemed like a good idea at the time, especially to Congress, Wall Street, and the other interests at the trough, which stood to profit enormously from these two new bureaucracies.
Thirty years later, at least from a certain standpoint, all these maneuvers have succeeded beyond their proponents' wildest dreams.
First, for better or worse, more than 70 percent of American families now own their own homes, or at least possess them so long as they can still afford to service their mortgages.
True, we might well now permit ourselves a few second thoughts about the sustainability of the resulting overall pattern of urban development. Many single-family homes, for example, were constructed to take advantage of artificially-cheap mortgages, temporarily-cheap energy, heavily-subsidized roads, and temporarily-abundant open spaces. In the wake of our rising energy costs and climate crisis, the resulting low-density, highly-distributed network of isolated, oversized, energy-inefficient housing has become an urban planner's nightmare -- and yet another reason why Americans are experiencing so much frustration with their current "high-cost" lifestyles.
Second, the influence, economic and political, of the two giant pro-housing GSEs has grown way beyond what anyone ever expected.
They now guarantee more than $5.3 trillion of mortgages and related securities, almost half of all mortgages outstanding. Treasury Secretary Paulson's plan to secure their stability by having Congress approve an unspecified US government credit line to them may or may not be a successful stop-gap -- the US budget deficit is already likely to exceed $500 billion this year, even without it. But at least the Paulson approach would stop short of the risks posed by outright nationalization -- if US Government were forced to guarantee all this debt, this would nearly double the size of the public national debt overnight, and expose the Treasury to much larger losses on this "underwater" mortgage portfolio.
Furthermore, the central banks of countries like China, Japan, and Russia have also accumulated at least $1 trillion of Freddie Mac and Fannie Mae debt, on top of $3.8 trillion of US Treasury liabilities that is held by foreigners -- including 57 percent of long-term Treasury bonds.
China alone reportedly holds more than $600 billion of GSE debt, one fifth of its $3.25 trillion national income.
More generally, the US current account deficit is now close to 5 percent of GDP, and may even soon start growing again relative to national income, further increasing dependence on foreign capital.
So this is no longer just a good old-fashioned “domestic US” debt crisis by any means. Since the US is (still) the world’s largest market, the engine of growth for many developing countries, and a traditional safe haven for investors and central banks all over the world, this may turn out to be the world’s first truly global debt crisis, affecting rich and poor countries alike.
Once we add up the potential losses of global wealth and income, if it were allowed to get out of control, it could easily dwarf the “S&L” debt criss of the 1980s, the Japanese debt crisis of the 1990s, and perhaps even the $4 trillion Third World debt crisis, where ultimate debt relief has totaled just $310 billion.
Not surprisingly, stock markets in China, Europe, and Japan have recently followed US stock markets into the tank.
It used to be a rule of thumb that whenever a Mexican or Argentine Finance Minister found it necessary to declare more than once a week that his country's currency was "really sound" and not about to be devalued, it was time to short the currency.
During the second week of July we were treated on at least three separate occasions to assurances by Treasury Secretary Paulsen, Federal Reserve Chairman Bernanke, and the head of the FDIC that the GSEs and the vast majority of US banks really are "well capitalized" and nowhere close to failure.
Their job is complicated by the fact that this is an election year, when politicians are especially reluctant to take actions that would offend key constituents
This includes like Fannie Mae and Freddie Mac themselves, for example. Since 2000 they have spent more than $190 million on lobbyists to press Congress and the White House for looser lending standards and weaker capital requirements.
They have also marshalled their allies on Wall Street, where investment banks receive hundreds of $millions each year in GSE underwriting fees; scores of real estate law firms across the country that live off the droppings of the FNM/ FRE mortgage documentation; and pro FNM/FRE "homebuyers" groups in every Congressional district.
Needless to say, all this influence peddling has not ben used to secure regulations that might constrain FRE/FNM growth and profitability. After all, even senior managers and stockholders of GSEs want to get rich.
FROM LYNDON'S WAR TO GEORGE'S
After two decades of financial deregulation and the growth of this powerful "housing-finance complex," therefore, all that was needed to create the speculative bubble and the spectacular bust that we've just seen was a compliant Federal Reserve and yet another Texas President who was reluctant to raise taxes to finance yet another unpopular war.
So, another 40 years later, we have inherited the very same combination of burst bubbles and excessive debts, heavily financed abroad and wasted at home, that we usually associate only with "submerging markets" in Latin America, Africa, and Asia.
Let's just hope that this time around, our newly President will have the intestinal fortitude to clean up these Augean stables when he takes office in January 2009. Otherwise we will continue to be plagued by self-interested deregulation -- on top of natural disasters like housing slumps, oil price spikes, and war-like Presidents from Texas.
(c) SubmergingMarkets, 2008