Does Too Big to Fail Mean Too Big to Change?

Now that we, the taxpaying electorate, have bailed out Wall Street, Wall Street is mightily resisting all efforts toward effective financial regulatory change. The proposed independent consumer protection agency seems likely to end up a division of the Fed. That would be the same Fed that famously insisted there was no housing bubble--right at the peak of the housing bubble. If they can't see the problem, they won't fix it. Consumers, emptor.

Investors, emptor, as well. It now seems that the concept of a fiduciary duty probably will not be imposed on stockbrokers. Too bad, since it would have required stockbrokers to put the customer first--admittedly a quaint notion but one that might restore some confidence in the financial markets. But given how the Treasury Department and the Fed have persistently put Wall Street first, with taxpayers and everyone else second, it's hardly surprising that Congress and the administration don't see why investors, who crucially furnish the capital that fuel the financial markets, should get a break.

The derivatives market--the shadow banking sector whose unregulated rambunctiousness made the mortgage and credit crises of 2007-08 possible--continues to dodge and weave away from serious efforts at reform. While the CFTC and SEC are pushing for change, one gets the sense that power brokers are quietly maneuvering at Congressional fundraisers to put concrete shoes on derivatives reform and take it for a nocturnal boat ride.

The "Volcker Rule," a proposal to separate taxpayer supported federally insured deposits from high risk bank proprietary activities, seems to have run afoul of a basic Wall Street principle: money talks and fairness walks. The financial sector, once the epitome of free markets, now seems never to see a federal subsidy it doesn't like. Moral hazard is good for profits, and profits are good for bonuses. Wall Street will pig out on as much federal largess as it can scoop out of the hands of taxpayers.

All this isn't surprising when one considers that the basic structure of Wall Street was saved in the bailouts of the last 18 months. The big banks now follow the imperative of all organizations and endeavor to preserve their status quo. Given their enormous financial power, restored by dumping a lot of risk and loss onto the backs of taxpayers, it's hardly surprising they can wheel in panzer divisions of lobbyists and roll back their opposition.

Too big to fail, therefore, may turn out to mean too big to change. The financial behemoths that played crucial roles in the recent financial crisis may escape largely unscathed and unchanged. What, then, would prevent a recurrence of the crisis? The tale of Fannie Mae and Freddie Mac may be instructive. For decades, Fannie and Freddie used their enormous financial resources to fund the most powerful lobby in Washington, bar none, while their officers and other personnel relentlessly made self-interested campaign contributions. Key members of Congress of both parties became running dogs for Fan and Fred, snapping up all the doggie treats tossed in their direction. All efforts to reform Fan and Fred, and reduce the systemic risk they presented, failed miserably. It was not until they, along with others, created a bad mortgage loan tsunami that overwhelmed every sea wall in the financial sector that the government, facing economic Armageddon, seized control of Fan and Fred, and put an end to their lobbying juggernaut. But the cost of nationalizing them has been hundreds of billions--a premium price for regulatory reform.

Not changing the landscape of financial regulation won't improve things, not in the short or long run. It would only set the stage for another crisis, one that very possibly will be worse than the recent one. The doctrine of too big to fail seems to have saved and consolidated powerful banks that now are using their restored financial and political muscle to hinder and delay desperately needed regulatory reform. Although the key players--Ben Bernanke, Henry Paulson and Timothy Geithner--surely wouldn't have intended such a result, their very strongly held belief that one must save the financial sector above all appears to have led to this dilemma. There is no shame or gratitude on Wall Street, where money--and only money--talks. If taxpayers bail them out, they'll proceed with business as usual, even when, and especially if, increased regulation to protect taxpayers would crimp their profits. Chumps are not meant to be repaid.

A 2010 Tax Strategy for the Democrats: Reform the Estate Tax

Barack Obama's political strategy for this year's mid-term elections seems pretty clear. He will take action, working with the Democrats in Congress to enact legislation, and acting as the chief executive where legislative action isn't possible. The recent health insurance reform, adopted with only Democratic support in Congress, is the most obvious example. Legislation for financial regulatory reform is on the move; some sort of bill will probably make it through Congress this year. Obama's recent recess appointments of 15 nominees is another example of his apparent decision to make 2010 a year of action.

The ballooning federal deficit will likely require a tax increase sooner or later. This being an election year, expect a lot of hemming and hawing, and no increase. There is one tax measure--not an increase--that probably could be enacted this year. And if the Democrats try it and are blocked by the Republicans, the Democrats would score political points for trying.

That would be federal estate tax reform. The Bush 43 tax cuts are bizarrely structured to provide for no estate tax in 2010 but a reversion next year to an old $1,000,000 threshold for the imposition of the tax. This anamoly is, like so many things in Washington, a political ploy, this one designed to make the cost of the tax cuts appear lower than they'd have been if the estate tax had been permanently eliminated. This sleight of hand made it easier for Congress to sign off, with the presumption that someone else would fix the problem when the tax reverted back to the $1,000,000 threshold.

Last year, there was general agreement among Democratic and Republican power brokers that reform of the estate tax should revolve around excluding the first $3.5 million of the estate from taxation and imposing the tax on amounts above that level, with the $3.5 million threshold to be adjusted for inflation. However, amidst last year's squabbling over bank bailouts and bonuses, the surge of Tea Parties, faux bipartisanship over health insurance reform, and pandemic adolescent finger pointing by high ranking federal officials and prominent members of Congress, nothing was done about estate tax reform.

For understandable reasons, estate tax reform this year has been shoved to the back part of the back burner that isn't even lit. But a Democratic initiative to enact the $3.5 million compromise that existed last year might work to their political advantage this fall.

Although this year's temporary repeal of the estate tax sounds like a boondoogle for the wealthy, it actually includes a potential unpleasant surprise for many. When the estate tax is in effect, heirs and other recipients of inheritances receive a "stepped up basis" (i.e., a base value of the higher of the original cost of the asset or its value at the time of the deceased person's death). For many assets, like stocks, real estate and collectibles, a stepped up basis means that when the recipient sells after inheriting the asset, income taxes (usually capital gains taxes) will be calculated by subtracting the stepped up basis from the proceeds of the sale to determine taxable gain.

However, when there is no estate tax, heirs and other recipients of inherited assets do not receive a stepped up basis. They get only a "carry over basis" (i.e., the deceased person's basis, which could be much lower than a stepped up basis for assets like stocks, real estate and collectibles). Thus, if they sell, their income tax is calculated by subtracted the carry over basis from the sales proceeds. This will often result in much greater taxes.

A $3.5 million exclusion from estate taxation would benefit the upper middle class, in particular those whose estates run in the range of $3.5 million to a bit above $5 million. These folks (or their heirs, really) might be worse off with no estate tax. Their heirs would get only a carryover basis, and be potentially subject to taxation on much larger gains than they'd face with a stepped up basis. The $3.5 million exclusion would largely shelter upper middle class estates from estate tax, while conferring a stepped basis that would significantly shelter the heirs if and when they sold the inherited assets.

The larger an estate, the more the benefit from a complete repeal of the estate tax. But that is a temporary circumstance, since the estate tax returns with a $1,000,000 threshold in 2011. Then, both the upper middle class and the wealthier are subject to higher levels of estate tax.

At first glance, it might make sense for the Democrats to simply let the estate tax lapse back down to a $1,000,000 threshold. With the growing federal deficit and a middle class core constituency, the Democrats would seem likely to lean toward soaking the rich (and upper middle class). But elections today are all about capturing the independents, the swing voters in between left and right who often outnumber party loyalists on either side. The estate tax matters to many small business owners and farmers, who can accumulate over $1,000,000 in net worth even if their annual incomes are modest. Many professional and managerial couples in the Northeast or the West Coast can exceed the $1 million threshold by owning a suburban home in a good school district and having a 401(k) account or two. These upper middle class folks are often opinion leaders and frequent contributors to political campaigns. Although their numbers aren't large, their influence can be significant.

Estate tax reform would demonstrate that the Democrats aren't focused solely on extracting more from taxpayers. It would be a step toward tax equity, and an acknowledgment that those who have worked hard, saved diligently and perhaps created some jobs are entitled to keep a reasonable amount of their hard-earned wealth. It would align Democrats with the American Dream, the notion that anyone who works hard and lives prudently should have a shot at the brass ring. The $1 million threshold hits anyone who reaches the iconic status of a millionaire. Although $1 million isn't what it used to be, it still conveys powerful symbolism and having the estate tax kick in right when the American Dream is attained is the kind of thing that heats the water at Tea Parties.

Republicans would have a hard time opposing estate tax reform. The $1 million threshold is something they rejected with the Bush 43 tax cuts, and they would be compelled to vote in favor of raising it. Certainly, some of them would favor a more dramatic rollback of the estate tax. But others would realize that their outcries over the burgeoning deficit would clash with demands for abolishing the estate tax. Charitable and educational institutions in all Congressional districts, needing endowments now more than ever, would lobby for retaining the tax, putting Republican legislators in the position of damaging local institutions if they favor outright repeal.

Thus, the Democrats would probably secure enough Republican votes that estate tax reform couldn't be filibustered or otherwise blocked. Lifting the threshold would probably cost the Treasury some tax revenues, although the impact is less clear than one might think. Resumption of the $1 million threshold might not benefit the Treasury the most; it could benefit estate planning attorneys the most, along with the finance professionals managing the tax shelters that would blossom if the $1 million threshold took effect. If the Republicans somehow prevented the Democrats from reforming the estate tax, the Democrats could score points in the mid-term elections for trying.

Estate tax reform would position Democrats closer to the political middle, and give them credit for fostering tax equity. It wouldn't directly benefit most voters; only around 2% of estates were subject to estate tax when it kicked in at the $1 million level. But reform would brighten their dreams for their children, whom they hope will face estate tax problems.

The EU's Lesson in Civics

Sometimes, we are reminded that the civics class we took in high school wasn't just an occasion for the boys in the back row to pull pigtails and have snicker fests making fun of the goody two-shoe student government types who earnestly raised their hands all the time. The crisis over Greece's sovereign debt illustrates why effective government is good for business and the economy.

Late last week, the EU announced a bailout plan, of sorts, to provide Greece with assistance in case it could not successfully borrow in the financial markets. The details of the plan remain vague. One feature that was prominently mentioned, though, was that the IMF would supposedly participate in the bailout. Why include the IMF? In part, to spread the costs of the bailout farther, as a palliative to the frugal German electorate. Less publicized but probably more important is that the IMF doesn't just hand over money to distressed nations. It imposes tough love requirements for fiscal responsibility (read, fiscal austerity) that steer the borrowing nation back to the straight and narrow. These conditions fill a gap left in the EU's governance--namely that there is no means for the EU to compel its members to adhere to its fiscal standard (i.e., that their government deficits not exceed 3% of GDP). The EU ostensibly monitors its members for compliance. But oversight has failed, with Greece successfully understating its deficit for years, until it 'fessed up last fall to violations. And even if the EU had uncovered violations, it has no enforcement process to mandate improved behavior. Imagine a police force with defective radar guns, no cruisers and no ticket books, and you have the EU.

The IMF can produce results. The Asian Tiger nations caught in the 1997 currency crisis spent time in IMF boot camp, down on the deck giving twenty. Today, they are prosperous. The IMF cure involves painful economic adjustments and more than a smidgen of increased unemployment. So the threat of IMF involvement may push Greece to get right with the EU. But one high ranking EU official, Vitor Constancio of Portugal (a nation with its own sovereign debt problems), reportedly rejected IMF involvement. So the waters were muddied just as they were clarified.

The generality and absence of details about this bailout package raises suspicions that the EU is gaming the financial markets, announcing the discovery of the Seven Cities of Cibola without explaining precisely how to get there. Talk therapy is a cheaper way to keep Greece's borrowing rates from skyrocketing than cash on the barrelhead. When you get down to it, talk may be all the EU has to offer, because it has no way to compel member nations to contribute to a bailout, even if they've agreed to participate. Add the fact that Germany still hasn't committed to help fund a bailout, and one wonders whether "bailing" here means helping Greece or avoiding any role in helping Greece.

The EU's charter (the Maastricht Treaty) is weaker than the Articles of Confederation that the thirteen original United States had to abandon in 1789 in favor of a Constitution that provided for a much stronger national government. As much as today's conservatives might dispute it, the power of the federal government is a crucial reason for America's prosperity. It promoted the development of national transportation systems (railroads, airlines and interstate highways) and communications systems (a national postal service, the telegraph, the telephone, radio, television, and now the Internet). It subsidized the settlement of farm land (with measures like the Homestead Act and the Oklahoma land rush), and helped agriculture recover from the Dust Bowl (with Department of Agriculture programs and price supports). It promoted investor confidence after the 1929 stock market crash, and stabilized the banking system with the Federal Reserve system and federal deposit insurance. Many of these programs have had disparate regional impact, where one part of the U.S. subsidizes another part. But the nation as a whole has benefited and grown. While federal policy sometimes goes too far, the United States would never have become the world's sole superpower without a powerful federal government.

The EU has almost no chance of evolving into a single nation, the way the United States unified from semi-autonomous states to a single nation. Its differences are greater than those of the American states, and there is no looming military threat (like Great Britain to the fledgling United States) to impel unity. Thus, effective government will elude the EU and its sovereign debt problems are likely to continue. As long as the EU can mollify the financial markets with talk therapy, the status quo may limp along. But if Germany's parsimonious electorate is called upon to actually plunk down real cash money, we might easily see the beginning of the end of the EU. Greece cannot be ejected from the EU (its charter has no mechanism for expelling non-compliant members). But Germany has no obligation to fund a bailout or remain in the EU. Today, the Germans expect the Greeks to behave like Germans, and the Greeks expect the Germans to behave like Greeks. Neither is going to happen. Sooner or later, everyone over there will look across the Atlantic for a bailout. With populism roiling the political waters here, there will be no second Marshall Plan.

So the sovereign debt crisis is likely to continue unless the financial markets decide against the weight of the evidence that Greece is a good credit after all. And when you get frustrated with the way things are going in Washington, just look across the Atlantic for a reminder that things could be worse, maybe a lot worse.

Federalism in the Derivatives Market

Financial regulatory reform at the federal level is bogged down in a lobbying scrum. The Senate Finance Committee just voted along party lines to send Senator Christopher Dodd's bill to the Senate floor. But the outcome and timing there remains in unclear. All we know is that something might happen sometime. The subject with the least certainty of reform is the derivatives market.

The derivatives market was the scene of the crime for the 2007-08 financial crisis. Stupid, bad and fraudulent mortgage lending practices at the consumer level were greatly magnified by the profits and compensation that could be and were obtained from securitization and the creation of CDOs, CMOs, and so on. Derivatives seemed to magically transfer risk out of sight (and therefore out of mind), while generating Brobdingnagian earnings for Wall Street. Bad loans were transformed into "good" investments, and a lot of very smart financiers somehow concluded that if bad loans could thusly made good, then they should make many, many more bad loans in order to do more "good."

The sheer weight of all those bad loans--trillions of dollars worth--are a crucial reason why the economy remains stagnant. The housing market won't recover for years because of the overhang from foreclosures and homes with defaulted mortgages awaiting foreclosures. Much of today's long term unemployment is attributable to people, mostly men, who were formerly employed in homebuilding and now have nowhere to go. The derivatives markets have done great damage to the economy.

Moreover, it appears that many American municipalities bought derivatives products that turned out to be losers, costing them taxpayer money rather than saving it. The idea apparently was that certain derivatives, like interest rate swaps, could provide cities with a lower net cost of borrowing. But interest rates, pushed down by the Fed, have imposed costs on these cities rather than saving them money. Municipal services are being cut in order to make payments to big banks.

Some states may limit the ability of municipalities to purchase financial derivatives. The risks are seen as incomprehensible and therefore too large. (If you don't understand an investment risk, it's too large for you because you don't know how bad things can get.) Limiting municipal investments isn't new. Many municipalities can invest bond offerings only in extremely low risk investments; no junk bonds or penny stocks. There's nothing intrinsically wrong with taking derivatives off the table. It looks like some states won't wait for federal reforms. They'll change the derivatives markets their own way.

Meanwhile, across the pond, the EU is giving increasingly serious consideration to limiting trading in credit default swaps. Furthermore, the uproar over the use of derivatives to sweep sovereign debt under the carpet is likely to shrink the market for such maneuvers.

Wall Street's lobbying power is unsurpassed, and meaningful federal action to improve the regulation of derivatives cannot be predicted. But that doesn't mean everyone else will take their losses lying down. State governments may feel impelled to act. The EU clearly intends to act. The derivatives markets may be balkanized with a different set of rules every few hundred miles. The Street may get what it wished for--and then be sorry.

Of course, the big banks that are the principal dealers in the derivatives markets could revive an old, discarded Wall Street tradition and offer derivatives in ways that place the interests of customers first. But that would be so 20th Century.

Political Stereotyping: Why Health Insurance Reform Was So Difficult

Just about everyone agrees that America's health insurance system is broken and needs to be fixed. Why, then, has change been so difficult to achieve? There are many reasons. One very important but rarely mentioned one is political stereotyping.

Political stereotyping, as we use the phrase, means attacking a politician for fitting the stereotype of his or her party and background. For example, President Obama has been typecast by the tea parties and the right as a big spending, big government politician. Being a Democrat who espouses mostly moderate and liberal ideas, he is vulnerable to such stereotyping.

It's very difficult for any politician to achieve change when the change is susceptible to political stereotyping. President George W. Bush's "ownership society" proposal to change the Social Security system by cutting back on guaranteed benefits and introducing government-funded investment accounts was easily be typecast as Republican parsimony toward moderate and low income Americans. It was DOA.

But Medicare Part D, an expensive prescription drug benefit that looked suspiciously Democratic, was enacted during the Bush 43 administration. This program, although weirdly structured with a "doughnut hole" in benefits, contravened the political stereotype of George W. Bush and was adopted with considerable Democratic support. (Postscript: the Obama health insurance reform will close the doughnut hole, good news for the many retirees having high prescription medication expenses.)

Presidents are often successful when contravening their political stereotypes. President Obama encountered relatively light opposition to escalating the war in Afghanistan. President Clinton famously failed to reform health insurance, but was singularly successful in closing the federal deficit and producing a surplus (putatively a Republican aspiration if there ever was one). Clinton deregulated the financial sector, another seemingly contra-stereotypical policy that would unfortunately contribute to the 2007-08 financial crisis. He also reformed welfare to reduce opportunities for recipients to stay on the dole for long periods of time.

Farther back in time, Richard Nixon attained rapprochement with China, a step that a Democratic President would have been vilified for taking. President Eisenhower's expensive program to build the interstate highway system was an easier sell coming from a Republican President.

Programs that fit political stereotypes are usually adopted when the party in the White House has a large majority in Congress and the urgency of a crisis to invoke. Franklin Delano Roosevelt's New Deal wouldn't have been possible except for the Great Depression and the large Democratic majority in Congress. Lyndon Johnson's civil rights program followed from his landslide victory in 1964 and the increasing stridency over civil rights. The last great political battle over health insurance--the Medicare program adopted in 1965--also followed from the Democratic landslide of 1964.

Barack Obama's health insurance reform, approved by the thinnest of margins, was achieved only because of the sweeping Democratic victory in 2008 and the virtual breakdown of the status quo in health insurance. Nevertheless, with the Democrats having demonstrated the ability to deliver on a major program, they have overcome the disadvantages of fitting the stereotype. The yin and yang of Washington have shifted again.

China Bails as Germany Declines to Bail. Will America Bail?

The Chinese government is conducting stress tests on over 1,000 Chinese companies to ascertain how a rise in the value of China's currency, the yuan, would affect them. See http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ahhhMkrA.A.I. This happens at a time when the U.S. and other countries have complained about the strength of the yuan. Members of Congress have threatened to take action against China (although given Congress' record of alacrity on legislative initiatives recently, the Chinese would hardly be quivering in their shoes).

Nevertheless, it is potentially significant that China's government is scoping out the impact of re-valuing the yuan upwards. Americans and other non-Chinese shouldn't delude themselves that their complaints have much to do with China's apparent inclination to re-value. China's economic policies are driven by internal concerns. While the Chinese government hardly is a paragon of transparency, there's probably an overriding reason why China might now re-value the yuan. It has no good investments outside of China for future trade surpluses. The dollar, overall, has dropped during the last decade and can be expected to keep sinking. The Euro is suddenly looking shaky, with the recent surge of EU sovereign debt problems, hinky national accounting systems and preposterous posturing substituting for a solution. The yen offers low-yields and doesn't have attractive long term prospects, not with Japan's massive government debt.

The yuan, by contrast, is likely to be a good investment. Although there is currently a bubbly froth in China's real estate and credit markets (sound familiar?), the People's Republic remains on an upward long term trajectory. By raising the value of the yuan, the Chinese government reduces China's trade imbalances and the cash surplus it needs to recirculate to other countries. U.S. imports to China may rise, although you can bet China's government intends to encourage Chinese companies to redirect their attentions to domestic markets. Throughout the last 30 years of modernization, the Chinese have quietly made a priority of economic self-reliance, encouraging Chinese companies to improve technological applications and productive efficiency, with the goal of competing against and ultimately supplanting foreign companies selling in China. If the yuan is re-valued upward, China's push for self-sufficiency will intensify, and probably enjoy considerable success. Then, the Chinese government will look smart for investing in the yuan and bailing on the currencies of stagnating foreign nations.

Meanwhile, back at the ranch, the EU is starting to look less unified. The French have stepped forward and argued for an explicit bailout of Greece. The Germans, no doubt irked by the fact that France's gallantry would be funded by Germany's wealth, have intimated that perhaps Greece should depart the EU in order to pursue other opportunities (or something to that effect). On a subliminal level, it's disquieting to see France and Germany disagreeing over a nation in the Balkans. At least this time, neither stormtroopers nor poilus are on the alert.

Nevertheless, the Europeans seem to be drifting back toward the dynamics of continental relations in the early part of the preceding century, when nations seemed simply to misunderstand where their neighbors were coming from. France's President, Nicholas Sarkozy, by proposing a concrete bailout plan for Greece, was inviting Germany's Chancellor, Angela Merkel, to commit political suicide. Seeing as how Merkel worked her way up the political ladder to become Germany's first female chancellor, self-immolation isn't likely to be in her playbook. While the French electorate is surely applauding Sarkozy's efforts to allocate some of Germany's wealth to Greece, Germany's electorate will only encourage Merkel to flip Sarkozy a pelican, or something like that. This isn't likely to end in a cozy circle with everyone roasting marshmellows and singing Kumbaya.

Greece has threatened to go to the IMF for assistance if the EU doesn't soon come up with a concrete bailout plan. The Germans shrugged. Without German participation, there will be no EU bailout plan because France and other pro-bailout nations have only the courage of Germany's convictions.

Thus, it may pass that Greece goes to the IMF. That's when Greek prime minister George Papandreou's quiet visit with President Obama last week may acquire greater significance. While next to nothing has been said publicly about the purpose and outcome of that meeting, it wouldn't be a surprise to see an American contribution to the IMF not long after Greece applies for help. After all, doughboys and GIs twice went over there to solve Europe's problems. Greenbacks may have to make the same trip soon.

Robber Barons Redux in the Derivatives Market?

A recent story from Bloomberg.com reported that two large banks, Goldman Sachs and J.P. Morgan Chase, are using their market power to secure extra large helpings of collateral in derivatives transactions with hedge funds. http://www.bloomberg.com/apps/news?pid=20601109&sid=af6uIAFTSorY. For example, Goldman reportedly obtained $110 billion more in collateral on derivatives transactions than it paid out. In effect, it got $110 billion in low cost funding that it could reinvest at a profit. J.P. Morgan Chase netted $37 billion in a similar way.

On one level, we're glad that hedge funds dancing in the derivatives market are subsidizing Goldman and J.P. Morgan. Otherwise, the Fed might feel compelled to print more money to ensure plenty of cheap funding for the too large to fail.

But the Bloomberg story states that these two behemoths of the financial markets had their way with counterparties because of their market power. In the post-2008 financial markets, there are only a few firms that offer some derivatives products sought by hedge funds, and those few evidently make their customers pay full freight and perhaps more.

On the level of economic theory, oligopolistic behavior is undesirable because the oligopolists extract "monopoly rents" from their customers--i.e., profits above the level that a truly competitive market would provide. This misallocation of economic resources enhances the power of the oligopoly, which can use that power to further entrench itself and secure more monopoly rents. To restate the point in plain English, oligopoly power allows the already megawealthy to become even more indescribably rich.

Surely we taxpayers, who have already subsidized Wall Street to the tune of multi-billions, are gratified to learn that those clever kids at Goldman and J.P. Morgan Chase can look forward to even more wealth. But let's also consider the impact of this collateral disparity on market risks. The derivatives market has a zero-sum quality. If a risk is transferred from one party to another, it doesn't disappear. It simply lands in the second party's lap, who must then figure out what to do with the hot tamale. In a similar way, if more, rather than less, of the hedge fund community's funding is transferred to money center banks, that leaves less for the hedge funds. Prudent hedge fund managers, after having their arms twisted by bank counterparties for extra collateral, would shrink their asset bases in order to keep risk levels in line with their reduced circumstances.

But this is Wall Street. Profits talk and prudence walks. Reduce your assets, and you reduce your money making potential. Do we really think that, just because GS and JPM have reduced their risk levels, their counterparties will do so as well? Or might it just possibly be that their counterparties would simply live more dangerously?

We've seen this video before. It was called The Grasping Counterparties Who Ruined AIG's Entire Day. Recall that AIG reached the brink because its derivatives counterparties, with the largest being Goldman, demanded more collateral than AIG could deliver. Surrounded by a pack of ravenous counterparties, AIG would have been torn to shreds except that the federal government appeared in the nick of time with $180 billion to drive (or rather, buy) off the wolfpack. Goldman claims it was fully hedged from AIG risk. But in order to do God's work it took the taxpayers' money anyway.

If Goldman's and J.P. Morgan Chase's counterparties are now at greater risk, where would that risk fall if the markets turn sour? It's possible that the derivatives markets have become more fragile because of the increasing concentration of market power in the hands a few money center banks. Locating any such fragility is difficult, because the absence of financial regulatory reform leaves us with only the fog of opacity of the derivatives market, circa 2008--well, 2010. Of course, if there is a blowup, the Fed can always print some more money. And that's okay, because there never, ever will be any inflation again. At least, that seems to be close to what some high ranking government officials have told us and they couldn't be wrong, could they?

Maybe Not Bailing Out Lehman Was the Right Decision

Former Secretary of the Treasury Henry Paulson and the current Chairman of the Federal Reserve, Ben Bernanke, have been well-excoriated for their 2008 decision to let Lehman Brothers fail, rather than bailing it out like Fannie Mae, Freddie Mac and, subsequently, AIG. The charges leveled against them are to the effect that the financial markets expected a bailout, and Lehman's failure led to a massive credit lockup that turned a mild recession into the worst economic crisis since the times of Charlie Chaplin. Paulson and Bernanke are, at least implicitly, held responsible for the layoffs of millions of Americans, the near collapse of the financial services industry and the 50% drop in the stock market.

Now we have a bankruptcy examiner's report on Lehman's demise, which depicts a recklessly managed (or mismanaged, to be precise) firm on a hedge fund-like leverage rampage that artfully (in the Dickensian sense of the term) presented itself as an investment bank. Prominent among Lehman's shenanigans was the sly use of British repo transactions to sweep some of its leverage under the carpet at the ends of quarterly financial reporting periods in order reduce the firm's apparent leverage. Now that this stink bomb has exploded, a lot of former high ranking Lehman executives are denying knowledge of these British repos (called "Repo 105s") or not commenting. The auditors insist they did an acceptable job, although it appears they knew of the allegations of a whistleblower. And one can only wonder if, at its meetings, the board was focused on what would be served for lunch instead of the financial condition of the firm.

The press and blogosphere are now swarming the potential culprits like packs of ravenous wolves with litters to feed. Blame is being avidly and abundantly cast. Very possibly, it is well-deserved.

Perhaps, though, along with the zestful mud-slingarama, we should consider whether anyone comes out looking a little better. Maybe Hank Paulson and Ben Bernanke weren't so far off the mark. With what we now know about Lehman's true financial condition, we can see that a bailout would have been much more expensive than it seemed at the time Lehman collapsed. Outrage over bailing out undeserving Wall Street executives would have been all the more magnified if the shameless gamblers at Lehman had received the munificence of taxpayers. The chattering classes would have fulminated about immoral levels of moral hazard and the witlessness of the government allowing potential wrongdoers (top executives, board members and auditors) to live to fail another day.

It doesn't necessarily follow that a Lehman bailout would have precluded the need to bail out AIG. Perhaps, a bailout would have encouraged AIG to extend its leverage even more in the hope of trading its way out of trouble, like the losing gambler who goes in for a dollar after losing a dime. That strategy could have easily led to mega-disaster in the volatile markets of 2008. Then the taxpayers would have been taken to the cleaners even more than they were.

Did Hank Paulson have an inkling of what Lehman was up to? After all, he would have had access to the top levels of Wall Street, and it's quite possible that others on the Street sensed, if not knew, what was going on at Lehman. Did Chairman Bernanke field enough phone calls from Wall Street execs to get the picture? We may never know for sure everything that Paulson and Bernanke knew, heard, sniffed out or suspected. But, in the interest of Monday morning quarterbacking government officials fairly, let us consider that their decision not to extend the generosity of taxpayers to a bunch of rascals really wasn't all that bad. Indeed, had Lehman not gone into bankruptcy, we wouldn't have the comprehensive examiner's report to provide a better picture of how inept risk management in the financial system has been, and why financial regulatory reform, still stalled in Congress, remains desperately needed.

The Democratic Stock Market

If you believe what many Congressional Republicans and Tea Partiers are saying, the stock market should be down around 3,000. The deficit spending, tax raising Obama administration, hellbent on an expensive reformation of the health insurance system, would surely have driven the economy into the ground by now, with a socialist wasteland our only future. But the market is reaching post-crash highs almost every trading day, and scarcely a wisp of a cirrus cloud mars the clear blue skies over Wall Street.

The stock market and the conservatives can’t both be right. If conservative, free market economists correctly propound that stock prices rationally incorporate all public information, then the Democrats must be on the right path. Onward with health insurance reform, tax increases, etc. Otherwise, you'd have to deviate from free market orthodoxy and conclude that the stock market is really stupid. After all, those humongous deficits and tax increases are about as secret as Kate Gosselin’s new gig on Dancing with the Stars. Maybe now is the time to sell all your equity holdings before the market figures out what a mess things are and crashes.

Of course, conservatives wouldn’t admit that the federal government might be turning things around, even though that’s what some statistics indicate. If the turnaround is true, there won’t be much for them to scream about in the mid-term elections this fall. Voters won’t fix an economy on the mend.

The stock market could be wrong. After all, the Dow Jones Industrial Average reached its all time numerical intraday high of 14,279.96 on Oct. 11, 2007, months after the mortgage mess blew up. The market sure as heck missed the ball on that one. There is plenty of reason now to question the market’s upside potential. The economy is still losing jobs (the recent “positive” news was that it lost fewer than expected, but fewer jobs means less consumer spending). Consumer credit expanded a bit, although incomes haven’t grown and banks are still cutting credit lines. States and municipalities are likely to lay off many thousands of employees as their finances become increasingly strained. Imports and exports have both fallen, which isn't what rebounding economies do. And real estate won't ride to the rescue, not with home prices stagnant or falling.

Yet, one thing's for sure: stock indexes keep rising. That favors the incumbent party. If the market continues to be so friendly toward the Democrats, expect the fall elections to be contests.

Bernie Does Europe

The following is entirely fictional.

The man stood out clearly among the other visitors at the Butner, NC medium security facility. He was trim, and scanned the room with dark eyes. His precisely cut blue suit, narrowed at the waist, the scaloppine soles of his pointed loafers, and his muted silk shirt offset by a mauve tie, would have photographed well east of the English Channel. His face was locked into a faint, bemused smile. It was a well-practiced expression, one perhaps used to mask his thoughts and emotions.

He had no trouble spotting the inmate he came to meet. The latter, an older man who was short and lumpy, would have been obvious even if he hadn't been so often photographed by the press. The visitor waved.

"Mr. Madoff."

"Yes. It's nice to meet you, Mr., uh . . ."

"John Talent," said the visitor, with the accent of someone who'd grown up with light breakfasts, not large ones.

"Yes, Mr. Talent." Bernie suspected that the visitor's registry, where Mr. Talent would have signed in, would not be terribly revealing to the press should they get their hands on it.

"I have the package you requested. Five pounds of shrimp cocktail and a quart of cocktail sauce."

"Wonderful, wonderful. You have no idea how hard it is to get a decent appetizer around here."

"I can imagine, sir," said the visitor, with well-exaggerated sympathy.

"Well, Mr. Talent. What was it you wanted to talk about?"

"I seek insight about your . . . former method of business. That is to say, your financial success."

"My . . . well, I suppose I was successful for a while."

"Yes, yes. How did you succeed in persuading people to give you money, and then keep it there?"

Bernie paused for a moment, seemingly in thought. "It comes down to telling them what they want to hear. Investing consists of putting your money down on a promise. The key is to make the best promise."

"That is interesting in abstract," said Talent quickly. "Let us consider, however, the possibility that the interests raising money are, shall we say, in some difficulty and their difficulties are not entirely unknown."

"Well, let me think. Uhmmm . . . can you tell me what interests you're talking about?"

"Perhaps we can say they are European. More I cannot reveal," replied Talent, his smile tighter than ever.

"Well," said Bernie, through a mouthful of shrimp. "They would have to improve the promises. That is, increase the promised earnings or profits on the investment, and make it appear that they have a very good chance of paying the returns. Look for ways to enhance your revenue, while cutting costs. At least, promise to do those things. By the way, this is excellent shrimp."

"I am pleased that you are enjoying it. Now, let us hypothesize that a . . . bailout, I think the English word is . . . will probably be necessary. That would require a third party--someone to provide the bailout for the interests I represent, so that we appear stronger. How should we deal with the third party?"

"What kind of bailout do you mean: funds, a guarantee of debt, or something else?"

"Any and all of them. Everything is under discussion. The important thing is to inspire confidence among the creditors."

"The creditors," muttered Bernie. "So you are trying to raise money to pay off old debts falling due?"

"Ahhh . . . perhaps I have said too much. But this is true. We must raise money to pay old debts. And there is not so much time."

"And you need a bailout to give the creditors confidence about your ability to repay new debt?"

"Precisely. We have been searching for a bailout, a new source of funds or at least a guarantee."

"How is that search going?" asked Bernie, plunking three pieces of shrimp at once into the cocktail sauce.

"Not very well. The European parties we approached speak in generalities. They don't want to say yes, but they don't want to say no."

"Why won't they say yes?"

"Because they believe we will use the money for consumption, not for investment. So it will not generate new revenues. It is, how you say, like the Ponzi arrangement."

Bernie chewed in silence for a moment. "I see. Then, why won't they say no?"

"Because they have invested in us already. If they say no and we fail, they will be harmed."

"So it is against their interests to say yes, and against their interests to say no."

"Precisely."

Bernie took a deep breath, and then another mouthful of shrimp. "Then you need to find another sugar daddy."

"Pardon?"

"Another benefactor. A new player to give you a bailout. Perhaps someone some distance away, who is not as involved in the situation. You have been talking to Europeans?"

"Yes. Interested parties in Europe."

"Maybe you should hop over the pond."

"Are you speaking of America?"

"That might be the next place to try."

"How could we persuade America to help European interests?"

"Think of something you could offer America."

The visitor stroked his chin, and then spoke. "We have been the victims of speculation in the derivatives market. It is very aggressive and damaging. Perhaps we could offer ourselves as an example of why your government should increase the regulation of derivatives. Your president might be interested, because he wants to add more regulation of derivatives but is having political problems with those people, the lobbyists. The international situation would give him . . . how you say it, political leverage . . . to change the laws. The lack of regulation is increasing international instability. This way, the profit making devices used by your big bankers . . . you call them Wall Street, I believe . . . will now be used against them."

Bernie smiled wryly. "I guess it's fair to say that sometimes, American financiers do go too far, and then the law catches up with them."

"So, if we give your government an international incident they can use to their advantage, perhaps they would have some sympathy for our situation."

"Maybe. Everything would have to be done very subtly. Nothing can be explicit, because the American government has many problems within the country to deal with, and the American people expect their government to take care of problems at home first."

"I understand perfectly. We will be very discreet."

"Good luck, then. And don't hesitate to come back for more advice."

"You have been very helpful, Mr. Madoff. Next time, I will bring ten pounds of shrimp."

Currencies: the Latest Bubble to Burst. Is Municipal Debt Next?

In the leverage-fueled, easy money world of the turn of the 21st Century, life is just one asset bubble after another. The bubbles du jour are the Euro and the pound sterling. The Euro bloc and the U.K. seem to have achieved faux prosperity with gads of borrowed money, some of it carefully tucked away in quiet, little (or perhaps not so little) derivatives transactions.

But the problem with debt is that creditors expect to be repaid. As creditors sought to have their way, the Euro and pound lost value. This down trend may have been exacerbated by trading in credit default swaps, the hydra of the financial markets. Thus, derivatives seemingly not only heightened the bubble, they also may have intensified the pop. Government officials in EU nations now talk openly about restricting the use of credit default swaps for sovereign debt. The financial engineers of the derivatives markets will likely sprout two or more new contracts for the credit default swap if it is cut off from the sovereign debt markets. Europe will have to search long and hard for a champion to truly kill this beast.

Municipalities in the U.S. also availed themselves of the easy credit offered by not terribly transparent derivatives. Many now find themselves locked into long term contracts that are expensive to maintain and expensive to terminate. Their only consolation is that the Wall Street bankers who sold them these puppies are back to earning big bonuses, thanks to the American taxpayer. Municipal bankruptcies are rare, but perhaps will be less so in the near future. If local governments must choose between police and fire protection, good educations for children, and decent roads, on the one hand, or continuing to enrich multi-millionaire investment bankers on the other, it's not hard to imagine that the sanctity of contract will take a fall. The Bankruptcy Code is intended to give debtors a fresh start, and a goodly number of municipal officials are likely to proceed on the premise that all politics are local.

They may take inspiration from the Chinese government. A news story today on Bloomberg.com (http://www.bloomberg.com/apps/news?pid=20601087&sid=ay..a15ZCHJU&pos=3) reported that China's national government will repudiate Chinese municipal guarantees of debt incurred by financing vehicles local governments set up to circumvent municipal borrowing restrictions, and prohibit such guarantees in the future. Kinda of reminds one of the SIVs and other special purpose vehicles banks set up for mortgage-backed investments to circumvent capital and financial reporting requirements. This Chinese version of the problem doesn't, at first glance, seem likely to precipitate a currency crisis, since the unguaranteed loans appear to be held mostly by Chinese banks. Beijing's purpose is probably to cut back the vast quantities of credit in China that may send inflation spiraling upward. But the notion that governments need not kowtow to banks could acquire increased currency (pun intended) from the Chinese example. While the federal government, almost incapable of achieving even modest reform of the financial regulatory structure, is clenched tightly within the grip of Wall Street's lobbying machine, the populism sweeping the nation could find new expression in municipal bankruptcies, where local government officials could claim heroic status for themselves (and re-election) by telling the big banks to stick it.

Taboos of the Real Estate Crisis

Today's housing news was that contracts to purchase existing homes fell 7.6% in January from the December 2009 level. Last week, we learned that new home sales fell 11.2% to the lowest level ever recorded since 1963, when the Census Bureau began tracking new home sales. Clearly, in spite of an expanded buyer's tax credit, the housing market remains a sick puppy.

Relief measures have treated symptoms. Defaulting homeowners get opportunities to restructure their mortgages, but lasting success is infrequent. Homeowners who haven't defaulted have trouble getting relief, especially if they are underwater. Underwater homeowners are increasingly tempted to walk away from their mortgages, especially if the loans are nonrecourse.

Treating symptoms often doesn't cure illnesses. Dealing with underlying causes is usually more effective. But the underlying causes of the real estate crisis are taboo. They cannot be discussed openly, not by government officials, nor Wall Street bankers, nor real estate industry professionals, nor consumer advocates. Candor would reveal the intractability of the crisis. At the risk of offending everyone having anything to do with real estate, we offer a little candor.

The 30-year fixed rate mortgage doesn't make commercial sense. It is a difficult loan for banks to manage, since their costs (i.e., the interest expense of deposits and other borrowings) fluctuate while the rate on the mortgage remains fixed for a very long time. Before the 1930s, the 30-year mortgage didn't exist. For all practical purposes, it wouldn't exist today except that, since the Great Depression, the government has promoted it as a way to make home ownership affordable. We can't get away from it, because real estate values would probably take a great fall without its easy terms. Even today's shorter term adjustable rate loans have amortization schedules that contemplate a long term loan of 30 or sometimes more years, so they're really just an elaboration on the 30-year fixed rate.

Banks don't like to hold 30-year mortgages. These loans can be made only by mismatching a bank's shorter term liabilities (like deposits) against a long term fixed rate asset. This mismatch is a formula for lending disaster when short term rates exceed long term rates, and they have periodically, going back to the 1970s. That's why the secondary mortgage market grew so large, first through federal agencies like Fannie Mae, Freddie Mac and Ginnie Mae, and later through private sector innovations like the mortgage-backed security, the CDO, the CDO squared, and so on. Banks became accustomed to offloading their mortgage risks. But the securitization market blew up along with the real estate crisis and remains moribund. Banks haven't been able to adapt to a world without securitization. Mortgage loans are almost entirely unavailable except when they can be guaranteed by Fannie Mae, Freddie Mac, or another federal agency, and resold. Securitization is now a federal program, not a commercial market.

The government and many others continue to believe that if home ownership is good, more home ownership is better. While this argument might make some abstract sense in a middle school civics class, reality is that home ownership in America usually requires credit. Even if some level of home ownership acquired with credit is good, that doesn't make more credit-fueled home ownership better. Only so many people are good bets for mortgage loans, and after that borrowers become riskier. We found that out the hard way in the 2000s, when defaults by the risky borrowers drove down home prices. In a society where home ownership is largely based on credit, there is an optimal level of home ownership, and after that it's a bad idea. However, not one policymaker in a trillion will openly endorse this point.

Another taboo is the proposition that banks should book the full extent of their home loan lending losses. America's banking system continues to hold hundreds of billions of dollars of losses attributable to home financing. Booking these losses would require more embarrassment on the part of banks (along with more capital raising efforts), more official consternation over the stability of the financial system and kabuki outrage over banker bonuses, and more houses in foreclosure sales pressuring prices downward. But not booking them is clogging up the banking system. Banks are afraid to lend because they want to hold onto their cash as a reserve against these unbooked losses. The paucity of bank credit is a crucial reason why the economic recovery is so tenuous. Economic stagnation is likely with the banking system in neutral.

So the wheels spin, caught in the muck of mortgages that don't make commercial sense, a secondary mortgage market that doesn't function except as a government program, the assumption that we need to make more, and then even more, bad mortgage loans in order to advance the goal of home ownership, and the unwillingness of banks and their regulators to fully face up to the losses of the mortgage mess. There's hardly any room for market forces to operate--and that's why they hardly do. Housing isn't a market. It's a government program. It's kept on life support by government subsidies, and can't be weaned off of them because the price collapse that would follow would bankrupt America's middle class.

Perhaps over the next ten years, the housing market will gradually revive. But it will surely continue to be built on the precarious edifice of taboos. Too much of America's capital will be misdirected into housing. Government borrowings will absorb vast amounts of what's left. Manufacturing and other activities fundamental to economic strength will be left with scraps. Growth will be stunted. Americans will squabble over who pays for health care, Social Security and other obligations that seem overwhelming when a slow growing economy doesn't produce wealth commensurate with society's generosity. But taboos cannot be discussed, so we end this essay. Good luck.

The Donkey-Backwards Housing Finance Debate

One of the biggest questions in housing finance is how to revive the securitization market. During the housing boom of the early 2000s, banks earned massive amounts of fee and commission income by packaging mortgages into mortgage-backed securities. These securities were often sliced and diced into CDOs, CDOs squared and what not, in order to further entice investors (and speculators). What happened next is all too well known. The banks, eager to bulk up low-risk fee revenue while offloading lending risk, thought that if writing a lot of mortgage loans was good, then writing a shipload more would be even better. Lending standards dropped, to the point where banks didn't always document borrowers' incomes, as if to avoid learning that they shouldn't extend the loan. There were plenty of times when they shouldn't have, but did anyway.

That insouciance toward prudence dug a very deep grave for investor interest in securitized loans. Today, just about the only mortgage-backed securities that can be sold carry explicit U.S. government guarantees. Housing finance has become a federal program, and today's housing stock enjoys what is effectively a federal price support policy.

Needless to say, taxpayers can't support housing values indefinitely. In the view of bankers and many regulators, securitization must be improved and revived. The two potential improvements most often discussed are (a) requiring the banks that package mortgages to keep some of the lending risk, or (b) improving underwriting standards without requiring underwriting banks to keep some "skin in the game." The first concept is intended to keep the banks honest. But banks holding increased amounts of lending risk also must increase their capital levels. That is likely to lower profits, anathema to their executives suites and also not to the liking of some bank regulators, who seem to equate lower bank profits with greater aggravations for themselves. The second notion--improved underwriting standards--is clearly necessary, but insufficient by itself. Investors aren't prepared to put down their money with just promises of improvement.

The problem is the discussion focuses on what the banks (and regulators) want, not what investors would like. This is donkey-backwards. A revival of a private securitization market depends on the willingness of investors to plunk their cash onto the barrelhead. There used to be a notion in American business that the customer is always right. A little fillip of customer service--i.e., investor protection--needs to be added to the mix.

First, there's the issue of trust. Trust is the true foundation of the financial system. Investors no longer trust the banks at the heart of the securitization process. That's why the only mortgage-backed securities acceptable to investors today bear a federal guarantee. Banks hoping to securitize on their own seem to be viewed as little more than potential scofflaws. Serious regulatory reform--of both banking and the derivatives market--is essential. Consumer protection must be greatly strengthened, lending standards bearing a reasonable resemblance to prudence have to be enforced, and the derivatives market must become much more transparent. But the scope of reform evolving in current legislative proposals may be inadequate to reassure holders of capital.

Second, the securitization market as it existed in the early 2000s ceased to be risk-sensitive. Investors had no effective way to discern that they were buying bags of digestive waste, and banks securitizing loans ceased to care that they were selling the same. The absence of risk sensitivity created grotesque market distortions that resulted in millions of bad loans being made, which may have enriched underwriting banks but also led to the defaults and foreclosures that have been driving down real estate prices.

Risk insensitivity is the problem that the skin-in-the-game requirement is intended to fix. The continued desertification of the securitization market is a signal that not enough is being done. Further product development is required. Perhaps banks should agree to limit investor losses to a predetermined number of cents on the dollar invested. After that, the underwriting bank would bear all losses. The less the investment resembles a pig in a poke, the more likely people will buy. Such a provision would improve the quality of mortgages in the pool, which would benefit investors--and homeowners. Fewer low quality loans would be made. Even if home ownership levels fall, bad loans do not, in the medium (let alone, long) term, increase home ownership. They do, however, drive down real estate values when borrowers default and end up in foreclosure.

Another improvement would be for banks to open up their databases concerning the underlying mortgages to credit rating agencies, and indeed, investors, for analysis. People are more likely to buy if they can kick the tires and lift up the hood. Any competitive issues would be unimportant if all offerings are subject to inspection. Of course, this may make pricing more accurate, or, stated otherwise, fairer to investors. And that's the idea. People will pay a fair price for what they understand, but not a penny for the opaque, black box CDOs of yore. Bank profits would be lower. But the current miserly dialogue about minimizing the extent of improvements to the securitization process may be holding down underwriting banks' costs, at the expense of expunging investor interest.

The bank-centric orientation of reforming the securitization market isn't even leading investors to water, let alone inducing them to drink. However, if banks and regulators would give a nod to the holders of capital who've been taking it on the chin for the last few years, maybe they'd see the phoenix rise from the ashes.