Sunday, October 16, 2011

What "Occupy Wall Street" Needs to Know

At present, there is a protest movement against banks, often called "Occupy Wall Street." It has staged growing demonstrations in New York that have spread to other cities and, for that matter, to other countries.
There is something you need to know about banks and financial regulation if you are a demonstrator or are sympathetic with those demonstrations. Simply put: "The train has left the station." By this I mean, the time to stand up for "the 99%," rather than the rich bankers, was the Spring of 2009. It didn’t happen then, so it can’t happen now. This devil is in the details.

Harper has published a book, Confidence Men, written by Ron Suskind. This book has received shrill, antagonistic reviews by Jacob Weisberg, the chairman of Slate, and by Steven Rattner, a former investment banker. John B. Judis, a senior editor at The New Republic, published his own, mostly positive review, printed in the October 13, 2011 edition of the magazine. Judis begins his review by muting or cancelling much of the criticism of Confidence Men; then he begins an analysis of his own.

Judis’ review contains a very succinct and intelligent summary of Suskind’s coverage of the Obama administration early in 2009, when the new administration faced the critical issue of large, insolvent banks. Below is a summary of Judis’ review of Suskind’s coverage of this banking issue.
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In early 2009, at the beginning of the Obama administration, Lawrence Summers (Director of the United States Economic Council) and Christina Romer (Chair of the Council of Economic Advisers) wanted the big banks taken over, shut down and re-opened under new management.

Treasury Secretary Tim Geithner had been head of the New York Federal Reserve in September, 2008, when Lehman Brothers failed and ignited a worldwide financial panic. Geithner’s answer was to relieve the big banks of their bad loans and institute "stress tests" on them, only taking them over, temporarily, if they failed.

Obama sided with Summers and Romer at first, figuring it would "strike a blow for prudence" and "begin to change the reckless behavior of Wall Street and show millions of unemployed Americans that accountability flows in both directions." But, after long talks, the decision was to take over only Citibank – which was especially wobbly – thereby frightening the other banks into compliance with a reform agenda. But Geithner balked and the President wound up following his Treasury Secretary’s suggestions.

Financial reforms: Geithner and Summers preferred to delay reform to avoid rattling confidence in the financial sector. On the other hand, former Federal Reserve chairman Paul Volcker as well as White House Chief of Staff Rahm Emanuel wanted to propose reforms that would restrains the banks from repeating mistakes that led to the 2008 crash. Volker told the book author, Suskind, "Well, right now, when you have your chance, and their breasts are bared, you need to put a spear through the heart of all these guys on Wall Street that for years have been mostly debt merchants." Emanuel said that bank reform would be "political gold."

Obama agreed with Summers and Geithner; then he met with bankers. One of these bankers told Suskind,

"The president had us at a moment of real vulnerability. At that point, he could have ordered us to do just about anything, and we would have rolled over. But he didn’t. He mostly wanted to help us out, to quell the mob." But voters began complaining about the administration’s ties to Wall Street and, in Massachusetts, Scott Brown was leading a race for the late Ted Kennedy’s U.S. Senate seat. So Obama got tougher, announcing support for a "Volker Rule" which would forbid banks from using depositor’s saving to engage in proprietary trading.

Congressional Democrats introduced legislation to detach rating agencies from banks whose offerings they rated as well as proposals to subject derivatives to open trading on exchanges*.  But as the year wore on, Obama did not fight as these proposals were gutted or watered down. The Consumer Finance Protection Bureau was part of the final bill as signed.
 
Geithner’s theory of investor confidence suggests the administration had no alternative to coddling the big banks. Though other nations, including Great Britain, selectively took over banks, Obama was wary of a public fight with American banks.

Suskind posits that failing to regulate the banks opened the US economy to repeating the abuses that led to the financial crash of 2007-8. The reviewer doesn’t agree, but thinks the lack of control over proprietary trading and the weaknesses in the Dodd-Frank legislation could lead to "speculative enthusiasms" in the bill. Both the author and the reviewer at the New Republic find Obama ineffective in dealing with these critical causes of America’s on-going sour economy.

The entire review is online at: http://www.tnr.com/book/review/confidence-men-ron-suskind?page=0,0

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* derivatives are legal contracts that constitute bets on future events. In a manner of speaking, they are often used as a unique substitute for insurance, an alternative which does not require that any reserves be set aside. Nor is there the insurance protection against over-coverage (you cannot be reimbursed for 200% or 300% of home insurance no matter how many policies you take out – but you can buy 300% of derivatives for a catastrophe and be reimbursed for more than the gross amount of the catastrophe).

Derivatives were critical to the 2008 crash. They also magnify the current Greek situation of insolvency into a global currency crisis. They remain effectively unregulated, since most are not traded on exchanges; the majority of derivative contracts are sitting in file cabinets and are traded over Bloomberg machines. The "notational value" (which is the amount of payment required if an unlikely event happens as described in the contract) of all derivatives worldwide is over one quadrillion dollars, which is a thousand trillion, in other words, a million billion. Large banks – including all of America’s large banks – use derivatives by offering their own underwriting services as a "counterparty." This means that banks agree to step in if an unlikely event bankrupts the losing end of a derivative bet. In normal times, this is a money machine for banks, as they get paid fees for acting as a counterparty without ever having to do anything or pay out to anyone.

To please its customers and attract business, the nation’s largest insurance company, AIG, then a Dow 30 component, offered its services as underwriting counterparty for the derivatives of its clients free! Because the risks were balanced and therefore unlikely to carry any risk to AIG overall. AIG swallowed over $181 billion in federal money to stay afloat from 2008-9. Thanks to that, it still exists as a tiny shadow of its former self.

Got it? Banks are still counterparties for hundreds of trillions of dollars worth of derivative contracts. Compare this amount with the U.S.A. gross domestic produce of roughly $14.5 trillion. When there is a sharp, unexpected major market move, the banks themselves can go underwater. It happened in 2008 and the public provided the reserves that should have been set aside by the counterparties. Nothing effective has been done to prevent a recurrence of that crash, including the gutless, toothless Dodd-Frank legislation.

Proof that this is correct: The G7 nation with the highest bank reserve requirements, Canada, was unaffected by the crash of 2008.

It is likely that history will regard Obama’s failure to regulate derivatives in 2009 as his worst mistake as President.  A crash that sparks derivatives to the point of bankrupting the (banking) counterparties has the potential to be unstoppable, worldwide.

How likely is it that the "Occupy Wall Street" demonstrators are going to demand derivatives reform? I have low confidence in their sophistication in this area.

--the blog author

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