Reason Foundation

Bair on U.S. Bond Bubble Possibility

Posted on May 9, 2012, 9:09am | Victor Nava

The United States government, the Fed and financial markets don't have a great track record when it comes to spotting bubbles. The financial markets missed the dot com bubble in the late 90's and, more recently, the Fed didn't pay close enough attention to the housing bubble, which peaked back in 2006. Is it possible that we could be in the midst of yet another bubble?

There are potentially multiple bubbles starting to inflate, but In a column published last week in Fortune, former FDIC chairwoman, Sheila Bair (whom we've highlighted opinions from in the past), focuses  on one potential bubble in which we may be in the middle of. She argues that the U.S. is currently experiencing a bond bubble that is being fueled by the Federal Reserve. Bair argues:

"The Fed has maintained interest rates at or near zero for four years running, even though the financial system has been relatively stable since 2009. The Fed's actions have kept Treasury bond prices high (while keeping the government's interest costs low), but the fundamentals do not support the high valuations, given the fiscal mess we are in."          

Her argument is dead on. The Fed has maintained a zero interest rate policy since late 2008 and actively pursued policies designed to further lower interest rates on bonds (ex. Operation Twist, though it didn't quite work). What has been the result? When you look at countries in terms of their debt-to-GDP ratios, the United States (estimated at 104.8%) is among the likes of Ireland (104.9%), Portugal (110%), and Italy (120%).  But unlike our undistinguished company, we have fairly low bond yields on  10-year treasury bonds compared with the yields on comparable 10 year (9 year for Ireland) government issued bonds from the previously mentioned countries  (1.88% compared to 6.82%, 11.06%, and 5.44% respectively). This translates to higher prices on U.S. bonds (hence the inflating bubble analogy) than we should theoretically have.

Bair acknowledges that defenders of the Fed's policies will point to Japan as an example of a country, which has run up huge debts without experiencing a bond bubble burst. And in some respects we are similar to Japan, which has an astronomically high debt to GDP ratio (at 233.1%), yet only a 0.92% yield on its 10-year bonds. But Bair points out some key differences.

"Japan enjoys a trade surplus, and its debt is held domestically. In contrast we run persistent trade deficits, and foreigners hold over half our public debt. To the extent foreigners keep buying Treasuries, it is because Europe's problems are worse. In short, we are the best-looking horse in the glue factory. "

You know the country is in bad shape and there is some economic danger when defenders of the Fed's policies have to justify themselves by pointing to Japan, a country which has been economically stagnate for decades, as an economic role model. Beware the bubble bond. 

Considering Causes of Recessions vs. Rates of Recessions

Posted on April 27, 2012, 3:14pm | Anthony Randazzo

High school economics wunderkind Evan Soltas put an interesting chart (see below) on his blog yesterday that The Atlantic's Matt O'Brien pointed out to me, asking for a libertarian response. I lightly and respectfully undertake an attempt below.

Evan writes that he pulled the chart together from FRED and NERB data showing that recessions have slowed down considerably since the 1850s. This is not incredibly new information—it is widely understood that since the 1930s that volatility is much more subdued than in the 19th century—though I had not seen the information presented like this before, to Evan's credit. 

(The chart was an embedded interactive file so I had to take a screengrab to show it here, but check out the original on Evan's blog here.)

By itself this chart doesn't tell you much until you start putting pieces of information on it to extrapolate as to the cause. For instance, Evan argues: 

In libertarian circles, the late 19th-century is seen as the pinnacle of growth and of laissez-faire and treated with according reverence. That story is not really true. Statistics which show unprecedented growth during the Gilded Age, I worry, are either imprecise, inaccurate, or worse, gamed according to their start- and end-points... It would be very possible that [GDP] grew quickly in between the frequent recessions, but the data do not support such a case: from 1800 to 1840, real GDP per capita grew at 0.4 percent annually; from 1840 to 1880, 1.44; from 1880 to 1920, 1.78; from 1920 to 1960, 1.68; from 1960 to 1978, 2.47.

I don't want to put words in Evan's mouth, but it appears the underlying assumption is that it was the creation of the Federal Reserve, victory of new Keynesian economic policy, Glass-Steagall, deposit insurance, and a less laissez-faire system that enabled the faster growth in the 20th century. Furthermore, I take an assumption that our present state of fewer recessions and GDP average growth of 2 percent over a multi-decade period is preferable. (I'm happy to be corrected if I am in error on these judgments.)

While I have not dug into this specific data myself for any extended period of time (and it appears there was a detailed attempt here anyway), there are a few things to consider in performing such economic analysis. To start, recessions are not ubiquitous events. They are not created equal. Their causes matter more than their numbers. For example, we might prefer five recessions that are six-to-eight months long scattered between 2002 and 2012, all caused by over investment in tech firms like we saw in the wake of the dot-com bubble's burst, to the boom from 2002 to 2007, followed by the 19 month recession, and then three-plus years of tepid economic growth. 

In the former scenario we are less likely to see recessions substantially impact household debt or long-term consumption trends. Spending would tighten up for a few months, balance sheets would be cleansed a bit, but the level of toxicity would not be so dramatic as to cause the losses we've experienced in the wake of our most recent bubble's bursting.

In the later scenario we have only 19 months of recession to deal with as opposed to as many as 40 months of recession to wrestle with. And we achieve much higher living standards for at least half of the time period. However, there is no inherent, objective measure that suggests this is better than the alternative scenario that I set up.

Nor is my alternative objectively better either. If the causes of those frequent recessions were bank runs that caused liquidity tightening and wide-spread bankruptcies as businesses failed to get access to credit to finance their payrolls, then we might not see quick bounce backs and the effects of those regular recessions could bleed into each other creating the environment Evan's data suggests for the middle part of the 19th century (which did include a devastating Civil War, by the way). 

All of this merely points out that the frequency of recessions is a relatively unimportant data point. It is the sources of such recessions. 

So to the second assumption, on the causes of the decreased volatility. This is a complex question. I pointed out the declining savings rate of the 1980s, 1990s, and 2000s earlier today on this blog and how this contributed to the economic boom years following the end of Stagflation and the Reagan recession. Perhaps if there were no technical advances to give us credit cards or if we were a less trusting society we would have had slower economic growth. Would this change have then discredited Reaganomics or influenced the way we view tax rate impact on GDP growth? Probably. 

The point here is to merely suggest that GDP growth rates as higher in the 20th century on average relative to the 19th century don't suggest much about the realities of the Gilded Age. What would the 20th century have been without the technical evolutions that gave us cars, planes, global telecommunication, and computing power? Back in 2008, this country would have given up a lot to get a 1.5 percent GDP growth rate. 

Evan concludes that his chart and argument shows "a very different picture of America, when you think about it. Frequent recessions, slow growth, little improvement in living standards, profound inequality -- all of this against what we have (had?) in the postwar era: fewer recessions, faster growth, faster improvement of living standards, less inequality."

On its face this is an efficiency argument for the central bank era vs. a supposed lassiez-faire era. The problem is that this assumes the desirability of a recession rate, speed of economic growth, and level of equality all divorced from their causes. That's not a leap of logic we should lightly undertake. 

Sheila Bair on the Prowl, a Guide

Posted on April 16, 2012, 8:40am | Anthony Randazzo

My first thought when I read the soon-to-be infamous Sheila Bair op-ed in the Washington Post this weekend was to laugh out loud and share the $10 million-loan-for-everyone suggestion with the driver of the taxi I was traveling in through downtown D.C. My second thought was "damn, I wish I'd had written the case against ZIRP like that." 

In fact we have written similar arguments as the former FDIC chairwoman articulated her humorous and cutting commentary. But not in the tone that she was able to articulate, shining a light on what has truly become a farce: the Federal Reserve's free money passed out in bulk to Wall Street to "support" the financial system. The idea Bair proposes is completely crazy, but that is the point. She is just articulating what Fed policy is for the financial system, and it is no less crazy to be handing them billions in free loans. 

Here is a guide to understanding the Bair tongue-anchored-to-cheek op-ed. First she writes:

For several years now, the Fed has been making money available to the financial sector at near-zero interest rates. Big banks and hedge funds, among others, have taken this cheap money and invested it in securities with high yields. This type of profit-making, called the “carry trade,” has been enormously profitable for them.

So why not let everyone participate? Under my plan, each American household could borrow $10 million from the Fed at zero interest. [...] Think of what we can do with all that money. We can pay off our underwater mortgages and replenish our retirement accounts without spending one day schlepping into the office. With a few quick keystrokes, we’ll be golden for the next 10 years.

Such a suggestion is usually overheard at one of D.C. well attended liquor and beer distributing establishments. Well, except for the bond trading part. The difference between professional investors and Americans suddenly power-ball-lottery-winner rich is the disciple to "order up a few trades" as she puts it later in the piece. Theoretically, if everyone just bought sovereign debt and lived off the interest we could avoid an inflation problem of all that new money chasing far too few widgets made by a rapidly declining labor force. But it is much more likely that all that money would flow into the economy, ruining creditors who are paid back to complete the deleveraging cycle, but unable to buy much with the now worthless cash that has been paid back to them (via Fed helicopter).

Bair begins to expose her point when suggesting how the "carry trade" could be accomplished for America's new denizens of wealth: 

The more conservative among us can take that money and buy 10-year Treasury bonds. At the current 2 percent annual interest rate, we can pocket a nice $200,000 a year to live on. The more adventuresome can buy 10-year Greek debt at 21 percent, for an annual income of $2.1 million. Or if Greece is a little too risky for you, go with Portugal, at about 12 percent, or $1.2 million dollars a year. (No sense in getting greedy.)

This is actually what financial institutions have been doing with all that Fed money. The bailout was supposed to shore up bank balance sheets so the failed institutions could lend. Quantitative easing was supposed to free up capital from assets and let the fresh money boost the economy. Zero interest rate policy (ZIRP) has long been declared necessary to encourage borrowing and keep housing prices propped up.

But all this has done is contribute to a limping, recoveryless recovery. As we predicted in Reason magazine two years ago, we've been going "sideways" for a while. And that is Bair's beef with the Fed.

She also has a barb to throw at Congress:

Of course, we will have to persuade Congress to pass a law authorizing all this Fed lending, but that shouldn’t be hard. Congress is really good at spending money, so long as lawmakers don’t have to come up with a way to pay for it. Just look at the way the Democrats agreed to extend the Bush tax cuts if the Republicans agreed to cut Social Security taxes and extend unemployment benefits. Who says bipartisanship is dead?

Fair point. When it comes to actually helping the economy, Congress goes AWOL. When it is time to score some political points, compromise abounds (under the cover of something substantive happening). Bair doesn't hold back from going after social issues either in the piece:

Because we will be making money in basically the same way as hedge fund managers, we should have to pay only 15 percent in taxes, just like they do. And since we will be earning money through investments, not work, we won’t have to pay Social Security taxes or Medicare premiums. That means no more money will go into these programs, but so what? No one will need them anymore, with all the cash we’ll be raking in thanks to our cheap loans from the Fed.

[...]

We can stop worrying about education, too. Who needs to understand the value of pi or the history of civilization when all you have to do to make a living is order up a few trades? Let the kids stay home with us. They can play video games while we pop bonbons and watch the soaps and talk shows. The liberals will love this plan because it reduces income inequality; the conservatives will love it because it promotes family time.

The frightening thing is that many of these attitudes are prevalent in American society even without the $10 million loans. 

The tax code is skewed. The answer is not to raise tax rates—the income tax system is a terrible way to tax a society and just slows down the economy—but that doesn't make the lower tax rates paid by wealthier segments of society any less damning. At the very least, the incentive structure of the tax code is set up to drive assets into many unsustainable things (like housing) and away from funding public liabilities (as Bair notes). 

Education is screwed up in America as well. Test scores are stagnant. High school graduation rates are sliding. Labor force mismatch issues are becoming an increasing concern. And it hasn't taken $10 million loans to end interest in math and history in many corners of America. 

So is Bair's solution viable? According to her, "This is the best American financial innovation since liar loans and pick-a-payment mortgages... Some may worry about inflation and long-term stability under my proposal. I say they lack faith in our country. So what if it cost 50 billion marks to mail a letter when the German central bank tried printing money to pay idle workers in 1923? That couldn't happen here. This is America." 

Touche. 

There will probably be more than a few out there who don't get the joke. But building on a pattern of loans without paper work to make everyone indebted to the Fed is not a serious policy proposal. Rather, her point is to channel the incredulous feelings of the readers into a criticism of the fact that the Fed does exactly this proposed idea, just with financial institutions instead of households. 

It is crazy and it has to stop. 

A Financial Products Agency is a Bad Idea

Posted on April 3, 2012, 10:21am | Anthony Randazzo

Back in February Eric Posner and Glen Weyl, both of the University of Chicago and deservedly respected economic and legal minds, wrote a paper proposing a Financial Products Agency. The idea is relatively simple—just as the FDA must approve new food and drug products for consumption, an FPA should approve all new financial products with a test measuring for social benefit. 

This is a terrible idea for at least three reasons:

First, an FPA would not have stopped the financial crisis. Let us assume for a moment that this FPA existed in 1998. Back then, when subprime debt began to pick up its pace, there was little understanding of the risk that was building up in the system. We can't just assume that having an FPA would mean regulators have somehow gained hindsight. Regulators were aware of what was going on to the degree that they had the resources to manage and the expertise to understand and didn't do anything then. Let's assume again that the FPA existed in 2004. Around that time regulators like Greenspan and Bernanke were well aware of the housing bubble but either did not think the risks were that big or did not think it was appropriate to step in. With rising housing prices (that all the regulators never thought would go down) masking the risks of subprime debt by preventing defaults, it is very hard to believe that regulators at this FPA would have done much to stop the risky financial products Posner and Weyl blame for contributing to the financial crisis.

Second, the model of the FDA is not a great idea unless you want to stunt markets. While the public has come to depend on the FDA to keep them safe there are regular outbreaks of diseases and complications with medicine. Even approved products can be misused. Beyond this, there are numerous cases where the FDA has prevented positive health outcomes, such as slowing down cancer prevention drugs for political reasons or sheer incompetence. And given the bureaucratic nightmare that is the FDA, it is impossible to know what drugs have not been pursued simply to avoid the compliance and approval costs and headaches. What we do know is that there is a growing problem of drug shortages in the U.S. and it is in part because of the FDA.

Finally, the whole argument for an FPA is based on the premise that derivatives contracts were significant contributors to the financial crisis. But derivatives—even the most risky contracts—are innocuous vessels. Blaming them is like blaming money for the crisis or computers. Though an argument can be made that there was too much money via central banks and too much computing power pushing high frequency trades, it is not the money or the computers but how they are used in connection with the other factors that caused the crisis. Derivatives contracts became a problem because the underlying assets they were being created with were misunderstood and financial institutions did not properly hedge their risk. If AIG had set aside the necessary amount of capital relative to its risk exposure, there wouldn't be as much carping about derivatives. If lending standards had not fallen so low, the subprime debt levels that did exist would not have been there to generate such a massive amount of unhedged, misunderstood, risky derivatives for subprime debt in the first place.

Unfortunately, despite these problems, the FPA finds the approval of NY Times business columnist Gretchen Morgenson, who wrote over the weekend regarding this proposed idea:

It is a refreshing rejoinder to the mantra on Wall Street — and in some circles in Washington — that financial innovation is always good and regulation is always bad. Bankers often argue that complex financial products are among America’s great inventions. But given that exotic instruments played a central role in the credit crisis, it is worth questioning the costs and benefits of such financial innovations. 

I agree that it is always worth questioning and debating and wrestling with ideas. That is the best way to avoid getting tunnel vision on something. But in this case, the idea under consideration is not a very good one.

Ms. Morgenson makes the problematic assumption at the start of her column that regulators would somehow have behaved differently if there were an FPA before the crisis. "Imagine if there were a Wall Street version of the F.D.A.," she says, "How different our economy might look today, given the damage done by complex instruments during the financial crisis." But as we were just pointing out, there was lot of authority to limit Wall Street. Financial markets are and have been one of the most heavily regulated industries in the U.S. But the only thing that I can think of that would have actually changed regulator behavior prior to the crisis would be something that eliminated regulatory capture. An FPA, just like the SEC, would have been filled with bureaucrats more than willing to use a light hand on approval procedures to ensure they had a job with some firm after their civil minded spirit got drilled into the pavement of Manhattan with one to many luxury cars. 

Then, Ms. Morgenson begins to lay out the case for the FPA, noting that the Posner/Weyl paper argues we should be able to regulate financial markets because they are different from the real economy, where a more laissez faire approach is good. The two leading problems with this argument are that:

1. Financial markets are so interwoven with the real economy that you can't truly separate the two. Financial markets are the lifeblood of new businesses, which in turn are the lifeblood of the U.S. economy. So anything regulations that unnecessary restrict credit are actually hitting the real economy; and
2. The problem is not a lack of rules but the absence of the right rules. If we learned anything from the crisis shouldn't a key lesson be that a lot of rules without regulators smart enough or inspired enough to enforce them winds up with meaningless protections and a false sense of security. It is foolish to depend on this regulatory crutch again and again. It is literally insane.

The next piece of the Posner/Weyl argument is that derivatives that are risky bear limited social utility and can cause system risk. I counter by arguing that: 

1. Just because something has limited social utility does not mean it should be restricted. Fantasy baseball may actually reduce productivity at work places across America, for instance, and may not get past a social utility censor. But I'll join up with an Upper Peninsula anti-government militia if the government tries to stop me from competing for glory; and
2. Derivatives in a market that has too-big-to-fail banks may cause systemic risk—but the problem there is the bloated banks and the lack of handling failed institutions. If every bank had 75 percent capital requirements there would probably be very little derivative risk. Of course we'd also have a nonexistent banking system. The key here is to solve for moral hazard and improper incentives in the system, not try to limit financial activity on the other side of the equation.

Ms. Morgenson further carries the Posner/Weyl case forward by noting they also want the proposed FPA to measure financial instruments for "how they affect capital allocation, and whether they might add useful information to the marketplace." Again, a couple of points:

1. How could an FPA really understand where capital should be allocated? Every regulator under the sun thought that capital flowing to the housing industry was a good idea during the bubble era. Imagine the FPA arguing in 2002 that there was too much capital flowing to the housing industry. It never would have happened, and on the off chance that our revisionist history unearths a Mike Burry to have influence in this FPA, the counter political pressure would have been too strong to let them do anything. Everything politically during the bubble was pushing capital towards housing. The Bush "Ownership Society" mantra. The previous decade's changes at Fannie and Freddie and FHA. Basel rules favoring housing. Even a massive accounting scandal at the GSEs failed to really derail their political or financial activities, so strong were the pressures to increase home ownership rates.
2. And why should a financial product be disallowed if it doesn't provide useful information to the marketplace? If I want to structure a deal with my neighbor where we place a complicated bet on the outcomes of real estate values from the properties of people two streets over, with a few voluntary counter-parties financing the bet... why should anyone else care? Posner and Weyl may respond they would care if my personal failure on coming up short in the bet posed a risk to the financial markets. But I would again push back that the problem then would not be the derivative contract but the fact that the system was so poorly incentivized that I could become a systemic risk.

The Posner/Weyl paper says in the introduction that Dodd-Frank is an empty vessel and on this point we agree. My remarkes are not a defense of Wall Street today or the regulatory system. This FPA idea is just not the right response mechanism to that problem. 

STOCK Act Ready for Obama’s Signature

Posted on March 23, 2012, 12:52pm | James Groth

 

Following weeks of delays, Harry Reid and the Senate finally sent the worthless legislation that is the STOCK Act to Barak Obama. Barring a staffer dropping it into the toilet en route to his desk, it will become law momentarily.

The STOCK Act is little more than a desperate attempt by Congress to retain what little confidence and respect is left for them in the hearts and minds of the American public. It accomplishes nothing, and addresses a non-issue. We have written about this fact since the Act’s first introduction last fall, which can be found here, here, and here.

Despite the Act and the legislative process leading up to its finalized language being nothing more than political grandstanding, what the STOCK Act really represents is a missed opportunity. If Congress were truly serious about policing themselves and not merely interested in gaining back the trust of Americans through a useless law, they’d design and pass worthwhile legislation. We wrote about this in our previous article:

“To prevent members of Congress and their staffs from cashing in on their positions while in office, a law needs to require them to report all financial transactions in real time, on the date they are made and prevent them from capitalizing on any nonpublic information they receive from any source gathered in the course of their public service.

The proposed STOCK Act has enough loopholes to drive a truck through. A simple fiduciary duty law that covers all financial vehicles and transactions - stocks, real estate, derivatives, etc. - would be more likely to protect taxpayers’ interests. This law would be better able to spot Congress‘ dubious financial deals because it includes all avenues by which members are able to use their privileged positions to enrich themselves, and it immediately shares the details of the members’ financial activity.

To give the law some teeth and make members of Congress think twice about using their positions to get rich, the SEC or the Justice Department must commit to forming an independent unit actively monitoring congressional stock activity and prosecuting offenders, which isn’t happening now.”

We wrote that in December, and since nothing has changed in the Act to reflect anything beyond just stocks. The law will pass, Obama and Congress will cheer their feeble attempt to demonstrate integrity, and status quo will be restored.

Referencing the STOCK Act, Obama had this to say:

“After I sign this bill into law, Members of Congress will not be able to trade stocks based on nonpublic information they gleaned on Capitol Hill.  It’s a good first step.  And in the months ahead, Congress should do even more to help fight the destructive influence of money in politics and rebuild the trust between Washington and the American people.”

America is tired of first steps. Why not just get the job done right the first go around and then move on to the issues that are truly important to this country like debt reduction, tax reform, monetary madness, and a host of others. Congress doesn’t need to waste time “rebuilding trust” and conning the American public into thinking their decisions aren’t made by special interests and money. The STOCK Act isn’t real reform. It’s yet another missed opportunity and a distraction from what really needs to be done.

 

Goldman Sachs Scams Federal Reserve Operation Twist

Posted on March 21, 2012, 7:43pm | James Groth

Last October we penned a post pointing to the failed policy of the Federal Reserve through Operation Twist. We noted that since the first day of long bond purchases under Bernanke, interest rates have done nothing but rise, despite the intention of the operation to have them fall.

The reason of course for the rise in rates was because big banks, institutional asset managers, and primary dealers bought an ocean of Treasuries, Equity traded Treasury instruments, and Treasury derivatives in front of the Fed only to sell them all back to the Fed when Bernanke commenced their purchases last October. 

The following is from our previous post:

        

“The above chart is of an Exchange Traded Fund (ETF) that uses derivatives sponsored by Barclays PLC, a Federal Reserve primary dealer, to track and invest in longer dated Treasuries of maturities greater than twenty years. I have highlighted on the chart significant events surrounding the speculation, announcement, and implementation of the Fed’s Operation Twist program…Despite what is written in the financial press about “investors seeking safety in Treasuries pushing prices up and yields down,” in reality, it is nothing more than banks and institutions and especially primary dealers with the Federal Reserve moving money over to Treasuries – in this case to be paid off by the Fed once they begin their purchases. Why they choose to say “investors” implying you and me, I do not know.

I chose the ETF in this case to highlight also the distortions that exist and the manipulation that is possible using a derivative-backed product issued and maintained by a primary dealer of the Fed. In the three months beginning August 1 and ending October 3, this product returned 25.6 percent plus three dividends bringing the total return to 26.7 percent. A comparable index or portfolio of Treasuries over the same period would have returned around 14 or 15 percent. The largest holder of this ETF as of June 30, just before the run-up began, was Credit Suisse, another primary dealer with the Federal Reserve, which holds more than 25 percent of all shares. Clearly, as the chart shows, these banks, institutions and especially primary dealers with the Fed have successfully manipulated the market around the Fed’s actions and came away quite well.”

An update of the transactions from the SEC reveals that from October 1, 2011 through December 31, 2011, Credit Suisse sold 43 percent of those shares I highlighted above. Over the same period, Morgan Stanley, Barclays, Deutsche Bank, JP Morgan, and Goldman Sachs all sold between 24 and 60 percent of their shares. Goldman was the biggest seller. Theses six Federal Reserve Primary Dealers sold a total of 9,041,933 shares while the Fed was buying. That represents one-third of all shares outstanding.

 The following table shows the respective sales:

Goldman Sachs stands out in particular relative to this group because in addition to the sales listed above, Goldman also purchased 1,971,964 shares of a product that makes money based on the falling prices of Treasuries. It’s a big bet that interest rates will rise. All of these shares were purchased between October 1, 2011 and December 31, 2011 and represent about 9 percent of all shares available. No other firm even comes close to this figure.

I’ve updated the Treasuries chart to reflect the trading that has ensued since our last post:

What’s important to notice here is that while Treasury prices have been falling since the Fed first began their purchases, they have remained at elevated prices. Indeed, yields for 10-year paper currently stand at 2.3 percent. This has everything to do with the Fed buying over $40 billion worth of long Treasuries every month since October, counterbalancing the institutional selling and mitigating the pressure from negative bets from Goldman and others.

However, this will end in June. At that time Operation Twist ends, and the Fed will no longer be buying our debt. As a result, most market participants are anticipating yields to rise precipitously this summer. Short positions, in addition to those placed by Goldman, are already being allocated to this move, and Treasury yields are beginning to trend higher. Traders are also betting that the Fed will raise interest rates a year earlier than the stated “end of 2014” date as fed funds futures markets are pricing in a quarter point rise in the November 2013 contract.

So it seems that the market has thrown a giant wrench in the monetary policy intentions of the Federal Reserve. The Fed target rate was intended to be at zero for another two-and-a-half years, and Operation Twist was to ensure that longer term borrowing rates for the United States were to remain low to allow for deficit spending to aid in the recovery a la Lord Keynes.

Instead, Goldman and a host of other institutional players scammed the Fed ahead of their purchases and are now betting against its long-term efficacy. What’s more is that the 30 percent bull-run in the S&P 500 over the past six months, which coincidentally began on the precise date of the beginning of Operation Twist, October 4^th, has been largely fueled by freed-up capital from purchases by the Fed.

Without further accommodation from the Fed, there is little that can support both asset prices and the ridiculously low yields on not only Treasuries, but also corporates, munis, and junk (which are all at about half their historical average).

I guess that means QE3.

Without robust economic growth, there really is no other alternative.

Let’s hope that Bernanke is soon proven right by his efforts and the United States starts putting up 3+ percent GDP growth with stable inflation. I think we’d all prefer remembering him as our savior from economic collapse rather than Goldman Sachs’ biggest sucker.

 

The IRS Gets Sued for an Illegal Licensing Scheme

Posted on March 20, 2012, 3:33pm | Anthony Randazzo

Most people don't like to fight the IRS, but the Institute for Justice is not most people. Last week IJ sued the Internal Revenue Service for authorizing an illegal licensing scheme that is driving thousands of independent tax advisors out of business. Check out the video for the whole story.

IJ's website says: 

Congress never gave the IRS the authority to license tax preparers, and the IRS can’t give itself that power.

But last year the IRS imposed a sweeping new licensing scheme that forces tax preparers to get IRS permission before they can work. This is an unlawful power grab that exceeds the authority granted to the IRS by Congress.

The burden of compliance will fall most heavily on independent tax return preparers and small businesses. Unsurprisingly, big firms such as H&R Block and Jackson Hewitt support the licensing scheme. As The Wall Street Journal explained: “Cheering the new regulations are big tax preparers like H&R Block, who are only too happy to see the feds swoop in to put their mom-and-pop seasonal competitors out of business.”

These regulations are typical government protectionism. They benefit powerful industry insiders and at the expense of entrepreneurs and consumers, who will likely have fewer options and face higher prices. But tax preparers have a right to earn an honest living without getting permission from the IRS. And taxpayers—not the IRS—should be the ones who decide who prepares their taxes.

That is why on March 13, 2012, three independent tax preparers joined the Institute for Justice in filing suit against the IRS in the U.S. District Court for the District of Columbia. This lawsuit challenges the IRS’s statutory authority to impose this licensing scheme, and seeks to overturn regulations that would affect an estimated 350,000 tax return preparers, forcing many of them to stop working in the occupation of their choice.

See the full story here.

 

Securities Regulation Continues to Frustrate

Posted on March 19, 2012, 11:45am | James Groth

 

Ask any trader their opinion about regulators at the SEC or CFTC and they’ll respond with variants of one of the following two responses:

1.)    “Great people. My son’s godfather is a director at the SEC.” (see article)

Or

2.)    “They’re garbage, too busy watching porn to effectively do their job, if at all.” (see article)

These are agencies completely captured by the securities industry, and those traders who happen to be distorting or even blatantly breaking trading laws operate in absolute contempt, thumbing their noses at the sheer ineptitude of the would-be enforcers without any meaningful recourse.

The Wall Street Journal published an article on Friday reporting that the CFTC will begin studying high-frequency trading that takes place on commodities and futures markets.

From the article:

“the CFTC plans to hold the first meeting of a high-frequency trading advisory panel on March 29. High-frequency trading is "taking an even larger role in our market, a bigger impact," said Scott O'Malia, the CFTC commissioner who is spearheading the push. "You can't ignore a trading style that occupies 40% of our market on any given day," he said.”

And:

“Instead of just policing completed futures trades, the Commodity Futures Trading Commission will seek to watch the fleeting buy and sell orders that increasingly influence the market, CFTC Chairman Gary Gensler said in an interview.”

Never mind for a second that Gary Gensler’s previous place of employment was at Goldman Sachs where he worked for 18 years eventually becoming a partner and director of fixed income and currency trading, never mind that. What is of concern and extremely frustrating is that only just now, according these comments, the CFTC has decided to focus on orders and not simply transactions. Also, high-frequency trading is the market, 40 percent by their own admission and I’d argue much higher depending on the metric used. Ignoring trading that occupies nearly the entire market that these agencies are tasked to police is beyond comprehension.

Since the advent of electronic trading, manipulation conducted in markets is done through transactions AND orders. Perpetrators move prices by controlling both the bid and ask side of spreads and move prices without transacting anything in accordance with how their open positions are set up in the market being manipulated and other markets in tandem. If that is difficult to understand, the takeaway is that monitoring orders and not simply transactions is integral to discovering manipulation and consequently enforcing against it.

Anti-manipulation regulation has been in place for nearly 80 years for both CFTC and SEC regulated markets with the passage of the Commodity and Exchange Act and the Securities Exchange Act. Hats off to the ladies and gentleman over at the SEC and CFTC for finally coming around to at least monitoring for it. Using a federal agency measuring stick, taking 80 years to get up to speed may actually be regarded as commendable progress.

If that timeframe is any indicator, it comes as no surprise that the new laws charged to the SEC and CFTC through the financial overhaul bill have not even begun to be addressed.

Recently the Dodd-Frank Act amended anti-manipulation legislation to include the following provision:

“It is unlawful for any person to engage in any trading, practice, or conduct on or subject to the rules of the registered entity that-

Violates bids or offers;

Demonstrated intentional or reckless disregard for the orderly execution of transactions during the closing period; or

Is, is of the character of, or is commonly known to the trade as, “spoofing” (bidding or offering with the intent to cancel the bid or offer before execution).”

This provision has been effective since July, 2011 and yet no enforcement has been brought forth despite the language of the rule specifically prohibiting the practices of high-frequency trading. More than 90 percent of all orders entered on the Nasdaq and NYSE are cancelled, and similar percentages of orders for swaps, futures, and other CFTC regulated derivatives are cancelled. The orders are merely entered to influence prices both in the market they are entered and the corresponding markets they directly affect. Those orders are not at all actionable, meaning that even if a trader wanted to trade against them, the “liquidity” that is reported to the exchange is not available to transact. Orders are entered in front of or in fractions of, true orders directly “violating” their intent to transact. Similarly, these orders are not at all actionable and have full intention of being cancelled.

Yet, nothing has been done despite the legislation.

The SEC and CFTC are both requesting to have their budgets increased. The SEC wants a $245 million increase for a budget of $1.56 billion and the CFTC wants a $103 million increase for a budget of $308 million. That’s a 19 percent and 50 percent budget increase respectively.

Why? So they can hire more ex-Goldman and other ex-industry heavyweights to continue to ignore manipulative practices consistent with their history?

These agencies do not need more funding and they do not need new legislation if all that legislation does is provide an excuse to hire more manpower only to sit around ignoring its intent and instead resort to watching porn.

Layering on legislation and layering on inept or corrupt agents defines federal securities agencies. Throwing money at them simply feeds the cause. If financial overhaul was the goal following the crisis, it’d be wise to overhaul what’s broken: the SEC and CFTC.

 

Japan Reports Huge Current Account Deficit. Should the U.S. be Worried?

Posted on March 9, 2012, 3:46am | James Groth

 

Last January we highlighted that Japan was stepping up their foreign exchange borrowings through the Federal Reserve. They currently stand at $18.1 billion and have remained about that size since their initial borrowing in December. Though this amount is hardly alarming, it may possibly be an indicator of events to come.

Japan is in a precarious situation given the size of their debt, the demographics of their population, the history of their international finances, and the current trend towards current account deficits that could upset a very fine balance.

We detailed all of these elements about Japan last January in a blogpost and warned that if sustained current account deficits were to persist in Japan, the United States could find itself in a precarious situation of its own.

Sure enough, yesterday, Japan reported the largest current account deficit since comparable records began in 1985. It’s one of only five monthly current account deficits ever recorded, and by far the largest.

Below is an updated chart from our previous post:

The Financial Times wrote the following about the alarming shortfall:

“Following a full-year trade deficit in 2011, a first for Japan for more than two decades, fears are intensifying that the country is rapidly moving towards a lasting current-account deficit, which could lead to a reliance on foreigners buying government bonds. That, in turn, could drive up interest rates, threatening a fiscal crisis.”

Japan’s current account deficit is likely to reverse to a surplus next month, and many economists are not expecting full-year current account deficits for years to come. Given the size of Japan’s exports, one can hardly argue. Continued current account surpluses in the near-term are about as much of a sure thing as the Greek debt swap agreement that occurred just three hours ago.

But the writing is on the wall for it to happen sooner rather than later, and who knows, 2012 may very well see a full-year deficit. After all, no one expected Japan to turn in a trade deficit for 2011, and they did just that.

Point is, the future is unpredictable, and the US is not at all in a position to deal with the effects of Japan running deficits. Japan’s immediate solution would be to start dumping treasuries.

Politicians can banter all they want about the right time to begin reducing America’s debt and to curb spending. If, however, some exogenous shock occurs like say one of our largest creditors selling a trillion dollars in treasury securities, talk is cheap. The market, that we’ve all seemed to have forgotten, will make our decisions for us.

Our previous post can be found here.

 

How Justice Broke Down in the Mortgage Settlement

Posted on February 23, 2012, 5:06pm | Anthony Randazzo

Following on the commentary we published last week calling out the politically oriented nature of the mortgage settlement between state attorneys general and the top five mortgage servicers, I had an op-ed published by RealClearMarkets this morning that highlights the unjust nature of the settlement. And any judicial agreement that doesn't pass the "justice" test should be seriously reconsidered:

...rather than helping the housing market, all the attorneys general wound up accomplishing was pushing aside justice in lieu of political grandstanding.

The mortgage settlement lacked what should have been basic procedure for investigating claims of misconduct at financial firms. There should have been evidence collected, executives deposed, the facts presented, and restitution paid to those who were wronged.

But this did not happen in any meaningful sense - only a "small number" of cases were found where robo-signed foreclosure notices were served on households making their payments. And had the attorneys generals' case against mortgage services been taken to court, there would have been little evidence to persuade a judge or jury that $26 billion payout was due. [...]

Since the settlement has yet to be approved by a judge, it is still possible this "landmark" deal could be dismissed. The arbitrary $2.5 billion slush fund state attorneys general got in the deal should be grounds enough for a judge to reject this (ala Jed "Dread" Rakoff). The unjust treatment of mortgage investors being linked to a non-germane robo-signing case is even more substantial grounds for refusal.

See the whole commentary here.

The Coming Greek Default

Posted on February 22, 2012, 5:00pm | Anthony Randazzo

Over at Reason.com this afternoon, I have a new column on the Greek debt crisis. Last year we looked at the numbers on the blog and came to the conclusion that no matter what happens, Greece is going to default. With a new Greek bailout on the table, we update the numbers but come to the same conclusion:

The target is to get Greek debt down to just 120.5 percent of GDP by 2020. But a confidential 10-page report prepared for European finance ministers that was leaked on Monday suggests that the best-case scenario is closer to 130 percent of GDP by the end of the decade. Furthermore, the report suggested that if the bailout deal is not upheld on the Greek side, debt could rise to the 180 percent of debt-to-GDP range.  To put this in perspective, Greece should be at something more like 60 or 70 percent of debt to GDP to be a stable European nation. [...]

The second bailout is also based on overly rosy estimates of economic growth for Greece. Where the Greek economy has seen negative GDP growth of 7 percent recently and is projected to have no growth in 2012 or 2013, the target goal of 120.5 percent of GDP by 2020 assumes economic growth of 2.3 percent in 2014 and 2.0 percent in 2015. But growth from where?

Read the whole commentary here.

If you want to start making a list of reasons why Greece will default here is a starter:

• It took over a year for Greece to start mandatory public sector layoffs because of constant protests and demands from the Greek citizenry that they retain their paychecks with salaries three times the private sector and no requirement to actually show up for the job. 
• Greece consumes more than it produces—partly because its people are busy consuming and not working, and partly because it doesn't produce that much period. It is a tourist based economy that can't generate rapid growth needed to eventually draw in the revenues needed to pay their debts after this second bailout goes through (if it goes through).
• The Greek penchant for tax evasion isn't just going to disappear overnight.
• For Greece to really have a future the nation needs to take a collective pay cut (probably somewhere between 25% and 50%), but a Trojan horse is more likely to appear on their shores than this happening willingly. It would be much simplier to make this happen by getting Greece out of the Euro and going back to the drachma—but it'll take a default for the Euro to let Greece go. One way or the other, this is all inevitable.

For even more see these two interviews from earlier this week on the Greek debt crisis.

Monday on GBTV's Real News: 

 

Tuesday on RT's The Aloyna Show:

Bernanke and You: Charting His Control

Posted on February 22, 2012, 2:05pm | James Groth

 

Chairman of the Federal Reserve Ben Bernanke is largely responsible for the 1 percent interest rates under Greenspan in 2003-2004 that contributed to the housing bubble, and Bernanke is absolutely responsible for the $2.3 trillion of asset purchases and zero percent interest rates over the past three years. His policies, and his policies ALONE in conjunction with fiscal spending, are responsible for the following charts. The nearly one-to-one correlation has to do with the institutionalization of financial markets in commodities (backstopped by the Fed) over the past 30 years. Everything you read about growing global demand, diminishing supplies, global unrest, political instability, etc. etc. etc. is merely at the margin and largely the conjuring of the media to pocket whatever remaining disposable cash you may have left after the following has destroyed your purchasing power:

25 year copper price:

25 year heating oil price:

25 year corn price:

25 year crude price:

25 year wheat price:

25 year soybeans price:

25 year gold price:

The “crash” in commodities that took place during the winter of 2008 that saw crude prices drop from $150 per barrel to $30 over three months time in direct correlation with the fall in price of every other commodity was nothing more than a reversion to normalcy.  There was no crisis, no panic. It was the cleansing of exuberance, of stupidity, of irrational exploitation, of utter nonsense.

And now we’re right back. Thanks, Ben.

The difference now is that Americans are not insulated by high home equity and a strong labor market like during the lead-up to the bubble five years ago. The stock market may at present be robust, but the gains over the past three years priced in real terms relative to the rise in the price of commodities, particularly gold, is actually negative. It’s fluff.

Also, consider this: Bernanke likes to point to the fact that all the loans, totaling somewhere between $7 trillion and $16 trillion, made from October 2008 through early 2010 were paid back, and the Fed (and so the taxpayers) made money. The Fed just paid the Treasury $77 billion in 2011 and $80 billion in 2010 for the earnings on its balance sheet. Hey, great. But all that money just went to re-cap banks, institutions, insurance companies and the like to make outsize gains in the rally that was about to ensue, to the tune of 100 percent or even multiple doublings. If the Fed had just simply purchased $7 trillion of soybeans, for instance, taxpayers could have netted $4.3 trillion. We could have then paid for all of Obama’s deficits to date! Hurray, problem solved!

Investing ten percent of the world’s total GDP into soybeans may be impossible, but it’s not too far off as ludicrous as just giving it away to a handful of financial shells to re-inflate illusory wealth that never should have existed anyway.

This whole situation is far from simplistic, but understanding the effects is as simple as reading the charts. The price of such a diverse array of inputs (commodities) should not trade in such direct correlations as they have under the era of easy money, the stock and bond markets included. These movements will have a serious effect just as they did in 2008. Reversion to the mean is always inevitable in some not-always-observable fashion. To boot, the quicker they diverge, the quicker and harder they revert. Whether Bernanke succeeds with his monetary experiment by bringing up employment and GDP is not of concern if in a short-period thereafter it crumbles under its own weight.

 

Occupy the SEC

Posted on February 15, 2012, 5:04pm | James Groth

 

So as not to be remembered as mace-enticing defilers of public property, the more productive members of the “Occupy” movement have collaborated to produce the most comprehensive, coherent, and noteworthy assessment of the Volcker Rule on record. A non-profit group called “occupy the SEC” submitted a 325-page comment to the agencies tasked with implementing and enforcing the Volcker Rule, found here, which is of the thousands of submissions, one of the most educated and well-researched.

The authors of the comment letter sent to the Securities and Exchange Commission (SEC), Federal Reserve, Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency label themselves as “a group of concerned citizens, activists, and financial professionals with decades of collective experience working at many of the largest financial firms in the industry. Together, we make up a vast array of specialists, including traders, quantitative analysts, compliance officers, and technology and risk analysts.”

Though the group claims to be of the 99% with “bank deposits and retirement accounts that are in need of protection through vigorous enforcement of the Volcker Rule,” the comment letter goes far beyond simply calling out for help, and slinging mud at our giant banking institutions.

It documents scores of loopholes laden within the proposed rule that highlight either the sheer incompetence of the Volcker Rule’s authors or the author’s clear succumbing to regulatory capture from the lobbying efforts of the financial industry. The rule as proposed, from the point-of-view of occupy the SEC, is in need of serious reform.

Nearly every major financial institution, exchange, and industry group has submitted one or multiple comment letters, and has their hands all over the agencies adopting this rule and the legislators influencing it. It’s just one example of the crony capitalism rampant within high finance. Whether the productive members of a movement tarnished by ignoramuses have any breakthrough is yet to be seen. The rule is set to take effect in July. If trend is any indicator of the institutional growth in the financial industry, chances are, it will likely be more of the same.

 

Landslide! STOCK Act More Popular than Hepatitis

Posted on February 10, 2012, 3:53pm | James Groth

In what has been called a “legislative speed record,” the STOCK Act has been passed in both the Senate and House with 96-3 and 417-2 voting “yay” respectively after just two-and-a-half months of consideration. I wrote about the Act largely being a public relations stunt back in December in the Washington Times and in a blogpost last week highlighting the desperation of Congress to regain the public’s trust. Co-sponsor of the STOCK Act, Rep. Tim Walz (D-MN) said that hepatitis would be more popular than congress if the Act wasn’t passed.

Despite passing in both bodies of Congress, the STOCK Act must once again pass in the Senate as two major provisions were removed from the version originally passed in the Senate last week. One of the provisions requires that professionals who sell non-public information relating to legislation and rule-making to hedge funds and investors, so-called political intelligence, must register with the government like lobbyists. It was part of the original House bill, but is now nixed. The other provision, which “prohibits undisclosed "self-dealing" by state and federal public officials to ensure that officials cannot secretly act in their own financial self-interest at the expense of the public, and in violation of existing ethics rules and regulations,” was added as a rider by Sens. John Cornyn (R-TX) and Patrick Leahy (D-VT). It had been proposed on its own, but was snuck into the STOCK Act last minute because of the bill’s absolute certainty of passage. Both were removed by the House under the leadership of Rep. Eric Cantor (R-VA).

Though on the surface the latter provision may appear a worthwhile law, Joe Luppino-Esposito of the Heritage Foundation provides an insightful analysis to the contrary. He concludes:

“As appealing as it might sound to give members of Congress a taste their own medicine, this proposed amendment would have a more devastating, far-reaching effect on all elected officials, and in some cases private citizens, at all levels.  The amendment is a textbook case of overcriminalization: over-reaching federal criminalization, unclear terms, and inadequate criminal intent language.”

The rest of the STOCK Act has been kept more or less the same, although some of the language has been changed to include securities other than just equities and swaps as the original bill had intended. A provision preventing Congress and their staff from participating in IPOs premarket was also added. The so-called Pelosi provision was aptly named in regards to Rep. Nancy Pelosi’s (D-CA) husband’s participation in Visa’s IPO in the spring of 2008. It coincidentally occurred around the same time as legislation curbing credit-card swipe fees. Never mind that Pelosi’s husband is a multi-millionaire financier who has participated in multiple previous IPOs and is a long-term investor – not a trader. The fact that the legislation and the IPO coincided with one another is pure coincidence. The idea that Nancy Pelosi acted on inside information through her husband’s investment is absurdly ridiculous. I am not one to ever defend Pelosi, but this is blatant political maneuvering.

Rep. Walter Jones (R-NC) called the Pelosi provision “absolutely unacceptable” and “petty.”

Representative Jones should have included the entire STOCK Act in his comment, because that’s about the best summation of the whole legislation. Americans shouldn’t welcome this new law (it will sail through the Senate and Obama will sign it in a heartbeat) as progress, nor a sign of Congressional efficiency, nor an occasion to restore trust in Congress. They should see it merely as a giant waste of time, a distraction from the real issues Congress should be dealing with, and a shining example of the spectacle that is American Politics.

Senate Approves Lawmakers Insider Trading Ban. Whatever.

Posted on February 3, 2012, 11:01am | James Groth

 

After a “60 Minutes” report brought to the attention of the American public that Congress was capitalizing on non-public information, lawmakers quickly collaborated with one another and proposed two bills banning insider trading by members of Congress and their staff. One in the House and one in the Senate. The House bill had floated around for six years largely ignored until it was immediately embraced by 270 House members the week after the public became informed.  The Senate bill took about two weeks to craft following the “60 Minutes” report. Isn’t it amazing how quickly our representatives can act when the issue threatens their lives and jobs?

This whole hoopla over Congressional insider trading is a non-issue. I wrote an op-ed in the Washington Times about this bill being largely a public relations campaign, a sorry and despicable attempt by members of congress to regain America’s trust by drafting and passing a law that at first glance looks like our representatives protecting our interests, but in reality accomplishes next to nothing and may even disrupt existing insider trading laws.

Congress has a public approval rating below 15 percent, and this bill reeks of desperation.

One of the creators of the Senate bill, Sen. Scott Brown, Massachusetts Republican, had this to say:

"We can send the message to the American people that we're trying to re-establish the trust that seems to have been lost with them, and who knows, maybe we'll be in double figures in terms of the approval rating pretty soon."

Co-sponsor of the House bill, Rep. Tim Walz, Minnesota Democrat, had this to say:

"If this thing doesn't move and doesn't happen, hepatitis will be more popular than the U.S. Congress, I can guarantee you that.”

The only thing that was accomplished throughout this lawmaking process was media time for our representatives to return to the pulpit, clamor to regain our trust, and most importantly, waste our time while not devoting much needed attention to real issues like deficit reduction, tax reform, a slew of government housing issues, relentless money printing, and the list goes on.

At least some sense came from one Congressman who voted no to the legislation. Sen. Tom Coburn, Oklahoma Republican, had this to say:

“The assumption here is that some of our colleagues are doing insider trading on the stock market. Nothing could be further from the truth. The real insider trading is the horse-trading that goes on in this body that is not always in the best interest of the country.”

Well said.

 

Freddie Didn't Bet Against Homeowners, It Gambled With Taxpayer Money

Posted on January 31, 2012, 9:12am | Anthony Randazzo

This is one of the last places you will find me defending Freddie Mac, but as much as I would like to pile on to the recent story that Freddie "bet against homeowners" the reality is that the nature of the story completely misses the point: Freddie gambled with taxpayer money.

It all started yesterday with a story from ProPublica, who normally does great work, and NPR claiming: 

Freddie Mac, the taxpayer-owned mortgage giant, has placed multibillion-dollar bets that pay off if homeowners stay trapped in expensive mortgages with interest rates well above current rates.

Freddie began increasing these bets dramatically in late 2010, the same time that the company was making it harder for homeowners to get out of such high-interest mortgages.

The problem with this story can be best communicated in the form of a Jeopardy question (I'll take Really Simple Finance Concepts for $2,000)...

Answer: A bet that pays off if homeowners stay trapped in expensive mortgages with interest rates well above current rates.

Question: What is a... mortgage.

Yes, in fact, all mortgage investments are worth more at higher interest rates. All mortgage investments lose value if they get refinanced, and thus prepaid. Finance 101 teaches that if interest rates go down, then investors in mortgages with fixed-rates make money. If people refinance those mortgages, then the investors lose money.

So why all the news stories (beyond the banality of news cycle driven journalism)? What exactly did Freddie do? Well, The New York Times writes it one way:

Beginning in 2010, Freddie bought several billion dollars’ worth of “inverse floater” securities — essentially the interest-paying portion of a bundle of mortgages — for its investment portfolio while selling the far less risky principal portion. Fannie and Freddie are supposed to be decreasing the size of their investment portfolios.

To read this you would think that Freddie never before made investments with interest-rate risk, and that their portfolio was growing. In fact, almost every mortgage Freddie Mac owns has interest-rate risk—since almost every mortgage investment everywhere has interest rate risk. Furthermore, their total portfolio decreased 4% in 2010 and 4.1% in 2011. This is much slower then they should be reducing their portfolios, and it reflects how the government is trying to use the GSEs to help homeowners, but the point is that the story framed by the New York Times is misleading.

Here is a more clear way of understanding what they did:

Freddie creates a security (MBS) backed by mortgages it guarantees which was divided into two parts. The larger portion, backed by principal, was fairly low risk, paid a low return and was sold to investors. The smaller portion, backed by interest payments on the mortgages, was riskier, and paid a higher return determined by the interest rates on the underlying loans. This portion, called an inverse floater, was retained by Freddie Mac.

In 2010 and 2011 Freddie Mac's purchase (retention) of these inverse floaters rose dramatically, from a total of 12 purchased in 2008 and 2009 to 29. Most of the mortgages backing these floaters had interest rates of 6.5 to 7 percent.

In structuring these transactions, Freddie Mac sells off most of the value of the MBS but does not reduce its risk because it still guarantees the underlying mortgages and must pay the entire value in the case of default. The floaters, stripped of the real value of the underlying principal, are also now harder and possibly more expensive to sell, and as Freddie gets paid the difference between the interest rates on the loans and the current interest rate, if rates rise, the value of the floaters falls.

So, the reality remains that the conflict of interest inherent in holding an investment that makes more money when less prepayments occurs for both inverse floaters as well as any standard mortgage. Even if all you are getting is the interest stream then a prepayment wipes out all of the investment where as a prepaid whole mortgage investment would get the principal back. The thing is, though, that Freddie already got the principal back so on net the investment is not a substantially greater conflict of interest.

What is different though about inverse floaters is that they carry more risk. That part of the story above should not be missed. So even though the portfolio had decreased in quantity, the risk profile of the portfolio contained riskier investments. Freddie Mac in effect reduced the refinancing risks for buyers of its MBS, and took on a disproportionate amount of refinancing risk itself. That is gambling with taxpayer money to help out mortgage investors. So the Federal Housing Finance Agency, Freddie Mac’s regulator, asked Freddie to stop at some point last year.

In a statement released late yesterday, FHFA noted it had “concerns regarding the controls, including risk management, surrounding the inverse floaters” given that the investment strategy was putting taxpayer money on the line (every three months the Treasury Department covers all net losses for Fannie and Freddie as an ongoing bailout).

FHFA did not ask Freddie to "stop betting against homeonwers" as a ProPublica and NPR story falsely reported last night. In fact, FHFA explicitly clarified that the investments had no bearing on recent changes, announced last fall, to the Home Affordable Refinance Program, in which Freddie maintained stricter controls than Fannie on homeowners who owed less than 80 percent of their homes’ value.

In one sense the Freddie bet with taxpayer money was small. FHFA pointed out that only $5 billion of Freddie's $650 billion portfolio was held in inverse floaters. But a $5 billion bet with taxpayer money is still a problem. 

So what does this story boil down to?

The story amounts to a big to-do in educating America that mortgage investment makes the most money when people pay higher interest rates. The same as every other type of lending.

The story highlights the need to address Fannie and Freddie, who have been in conservatorship for over three years now. At the very least we should be forcing the GSEs to sell off their investment units and just be securitizers in the near-term—though Congress and the White House have been too cowardly to even discuss that.

The story amounts to paraded evidence that a private company seeking to make money might have some conflicts of interest if it also has a mission to fulfill some kind of social obligation (the essence of the government-sponsored enterprise model). Not really a newsflash there either, and we can avoid these conflicts of interest by getting rid of the two companies operating with the conflict of interest built right into their mission, but again, Capitol Hill seems to be primarily focused on their Bert Lahr impressions these days.

The story is NOT evidence of any kind of collusion at Freddie Mac that they purposely have made refinancing difficult in order for their special inverse floater investment to cash in—THAT would have been a story. But Jesse Eisinger and Chris Arnold, the Pro-Publica and NPR writers who "broke" this story, reported that:

No evidence has emerged that these decisions were coordinated. The company is a key gatekeeper for home loans but says its traders are "walled off" from the officials who have restricted homeowners from taking advantage of historically low interest rates by imposing higher fees and new rules.

Unfortunately, the way that story came out looks like it was just another tool for pushing an agenda for increased refis and forced principal modifications. The battle has raged for a while now: FHFA says that principal modifications would hurt taxpayers by causing losses at the GSEs and any other parties invested in mortgages or providing insurance for mortgages. The White House says it wants to fulfill a social mission and modify mortgages to address the massive negative equity problem. The Federal Reserve says that it thinks taxpayers may come out ahead with principal mods if the benefit to homeowners is greater on net than the losses to taxpayers generally... but that really shouldn't be a bet left to the Fed to make. 

Who were the economists criticizing Freddie for "betting against homeowners" in the lead story yesterday? NPR relied on Alan Boyce, a former bond trader who co-wrote a paper outlining a streamlined mortgage refinance program, and Christopher Mayer, who co-wrote the Boyce paper and is co-author of another detailed paper considered by the White House for how to pursue a principal modification program. Talk about conflict of interest.

Boyce said, "Freddie Mac prevented households from being able to take advantage of today's mortgage rates — and then bet on it." Ironically, this quote is from a NPR article that explicitly notes there is zero evidence to suggest this actually happened. But worse, Mr. Boyce knows that any mortgage investment owned by Freddie Mac with interest-rate risk would lose value on a prepayment, and he ignores that they too should be classified as "betting against homeowners" under his logic. 

PIMCO's Scott Simon says he is "shocked" that Freddie did this because the trades "put them squarely against the homeowner." Really Mr. Simon? As the head of a team that deals in mortgage-backed securities, then he invests all the time in mortgage products that are "against the homeowner" because most mortgage investments have interest-rate risk. That is kind of the point. You make a loan and collect the principal plus interest in return. Or, in the case of PIMCO or Freddie Mac, you buy the rights to getting the mortgage principal repaid plus the interest. If you buy the payment stream on a 30-year fixed-rate mortgage that has 6.5% interest payments on it, but five years after the mortgage was made it gets prepaid (either because of a refinance or home sale), then you lose out on those other 25 years of 6.5% interest payments. 

That is basic mortgage investing. 

The reality is that homeowners move roughly every 7 to 8 years, meaning that most mortgages are going to get prepaid eventually. The bet is that the mortgages you invest in will hold out for longer than others. Because there is a time factor involved.

As long as the government wants Freddie to help support homeownership, it is going to face the conflict of needing to make money from taxpaying homeowners as well as make what they pay for homeownership lower. 

Greek Debt Talks Stall, Again. What About Portugal?

Posted on January 30, 2012, 5:47pm | James Groth

After another attempt failed to get commitment from private investors on forgiving a portion of their Greek debt, the Institute of International Finance (IIF) maintains that a deal will be finalized shortly. Considering that the IMF, ECB, and a host of other European leaders have been claiming that a deal is “imminent” for the past three months now, this once again is as believable as MF Global assuring investors one week before collapse that it “is in its strongest position ever.” What’s worse is that while this circus of negotiations continues, Portuguese bonds and spreads are blowing-up.

Below is a chart of Portuguese 10-year bond yields over the past two years. Just today, yields rose 14.3 percent to an all-time high 17.4 percent yield.

Portugal is now in the same predicament as Greece and will have to go through the same bailout and debt reduction procedures as is currently occurring in the Hellenic Republic.

Greece is trying to lock down a $170 billion bailout from the IMF which will allow it to hobble along for the remainder of the decade. Reports surfacing last week say the figure needs to be at least $190 billion. Either way, in order to receive the funding, Greece must get a voluntary agreement from the private holders of its debt to commit to taking at least a 70 percent haircut (loss) on their holdings and take as the 30 percent remainder new 30-year Greek bonds with a coupon of somewhere between three and four percent. 10-year Greek bonds currently yield 34 percent.

Why anyone would choose to accept such a deal is beyond comprehension and may be why the talks have stalled for so long. It’s a terrible deal. Remember, the commitment from private investors is voluntary.

Private bondholders know exactly how much they stand to gain and lose by choosing to accept or decline a deal. Many of the bondholders are holding derivative contracts on their bonds and may actually benefit from a Greek default. Certainly none of them will cave to the scare tactics that holding out for a default would cause a financial meltdown, and regardless, even if they suspected a meltdown would ensue, I can imagine some of the hedge fund managers drawing pride from being responsible.

None of this would even be happening if markets were simply allowed to function. Greece would default, bond holders would line up for their share of the claims, derivatives would pay out, banks would take losses, Greece would design a budget sufficient to gain new funding at a market rate albeit with significant cuts, and voila, problem solved. Instead there is this political maneuvering from the IMF, ECB, and heads of State claiming where rates need to be set, who’s entitled to a bailout, and why a ten-year-old monetary union needs to be upheld because of regional peace for all reasons. As if free trade and free movement of labor had nothing to do with the last 60 years of peace in Western Europe.

So the unending political pandering and breakdown of securities market law continues and will double once the situation in Portugal hits the fan. Portugal is issuing debt this week, and when their government realizes where their financing costs have risen to, they’ll be whining for the same treatment their Mediterranean neighbor received.

They may want to be careful what they wish for. Over the weekend, Germany asked that Greece relinquish control over its budget to a central European authority and hinted that others in distress who would be receiving bailouts do likewise. That’s the last thing any nation would want, ceding decision making authority to an institution with limited knowledge beyond a ledger, and to boot it would come at the price of nearly a decade of painful austerity.

The Cordray Appointment

Posted on January 4, 2012, 5:30pm | Anthony Randazzo

Either Obama just overplayed his hand or the White House has baited the Republicans into looking like the party of "no" without much in the way of alternative ideas. This morning President Obama made good on this threat to make a recess appointment of Richard Cordray as CFPB director after months of fighting in the Senate over his nomination. The aftermath today has been verbally violent, with accusations flying left and right, with a top business lobbyist even predicting the appointment would be challenged at the level of the Supreme Court, in the midst of all of this, though, there is a lot of obscuring the various components of the debate, and we should make sure everything here is clearly laid out on the table.

To start with, it is undenable that the President has, in effect, bypassed the Congressional process established for the CFPB by the Dodd-Frank Act less than two years after the landmark legislation was passed. Whether you agree with the recess appointment or not, that is a fact. At the time of the Dodd-Frank debate, one of the most heated points of contention was the so-called Consumer Financial Protection Bureau. Those opposed to the idea said the then-proposed legislation granted too much authority to a single agency, gave its director too much power, and threatened the competitiveness of banks by separating consumer protection from financial safety and soundness regulation. I wrote on October 9, 2009 for Reason.com:

the CFPA will pile on burdensome new rules, restrict innovation, hurt small businesses, increase the cost of doing business, spawn a massive bureaucracy, and create severe conflicts between state and federal law. Frank's proposed version would even allow the new agency to write and enforce laws beyond the scope of existing legislative authority. There are good ways of reforming consumer protection. The Consumer Financial Protection Agency is not one of them.

Supporters of the CFPB idea ultimately countered that the fears were overblown, and that the bureau would be subject to strict Congressional oversight. Those promises have now been broken, making all those fears appear highly valid once more. Thus, the President's recess appointment means the young federal regulatory body will be born of blood, eschewing that Congressional oversight because the President "won't take 'no' for an answer." In fact, that is the whole point of a check and balance system. The President says, "I want this guy," and Congress says, yes or no.

Where this gets tricky is in the messaging. The Republicans have not so much been opposed to Cordray in his qualifications as they have been opposed to the office he wants to fill. The Senate GOP has blocked the confirmation of Cordray on grounds that they don't like the structure of the CFPB, the way it is funded, the authority of the director's office, and the fact that it doesn't have a commissioner structure like most other federal agencies. Their concerns happen to be valid, but their approach grants some validity to the President's recess appointment.

Technically, the law was passed, the CFPB created, and the office established. From a purely technical perspective, the President nominated a director and the Senate should vote up or down on that individual. The Republicans have used the nomination process as leverage to wage their war on the CFPB. Procedurally it is within the law, but the nature of the politics has understandably infuriated the White House.

In response, the President has resorted to a dubious ploy of a recess appointment. An appointment that runs counter to both established precedent going back the Clinton administration, but in direct contrast to the findings of Elena Kagan in April 2010 when she was Solicitor General.

Thus, the act itself is being questioned on constitutional grounds, and the U.S. Chamber of Commerce is considering filing a lawsuit (the USCC was one of the biggest opponents of the CFPB). 

The act happens to run counter to the president's own promise to stand in contrast with the Bush administration and not "use signing statements as a way of doing and end run around Congress." And the defense of the act is dripping with so much political BS that it defies logic. Consider this section from the president's comment on the recess appointment: 

 

…Every day that Richard waited to be confirmed was another day when millions of Americans are left unprotected. Without a Director in place, the consumer watchdog agency we’ve set up is left without the tools it needs to prevent dishonest mortgage brokers, payday lenders and debt collectors from taking advantage of consumers. That’s inexcusable. It’s wrong. And I refuse to take “no” for an answer. 

I’ve said before that I will continue to look for every opportunity to work with Congress to move this country forward and create jobs. That means putting construction workers back on the job repairing our roads and bridges. That means keeping teachers in the classrooms and cops and firefighters on the streets. That means helping small businesses get ahead. These are ideas that have support from Democrats, Republicans and Independents. And I want to work with Congress to get them done.

But when Congress refuses to act and as a result hurts our economy and puts people at risk, I have an obligation as President to do what I can without them. 

 

Even if you agree with the mission of the CFPB, what does moving the country forward to create jobs have to do with the CFPB? What does putting construction workers back on the job (jobs they only had because of the housing bubble in the first place) have to do with the CFPB. The President wasn't really equating the CFPB with job creation (to give him the benefit of the doubt), but he was wrapping the defense of his recess appointment up with his drive to usurp Congress on fiscal policy. The untrained listener will equate stopping the CFPB with stopping job creation—as if either party really does not want America "back to work." Politics as usual to be sure.

Ultimately, though, the question of constitutionality is the real challenge the President faces. His politics may be dirty, but the debate should center on the policy act itself. 

So that leaves us with four core elements of this argument:

1) We have the debate over whether or not the CFPB is structured properly (assuming it has to exist at all, which it should not, but that is a separate debate);

2) We have the matter of Republicans using the confirmation process to make a political point;

3) We have the question of whether Cordray is the right man for the job, assuming someone should be confirmed as director of the CFPB; and

4) We have the issue of whether or not the recess appointment was a constitutional or legal act.

There are also the campaign promises, ethics, the nature of Washington, etc. that I've mentioned that could go on this list, but even though I added it to the blog post I don't want it to obscuring the core elements here because the conflation in the public square today has led to lines being misdrawn in the sand and misinformed opinions.

Even if you don't like the GOP's tactic, that doesn't mean Cordray should have the job or what the President did was right. The Republicans have the right idea in wanting changes to the structure of the CFPB, but they are going to lose this political battle if they focus on just that—there are many problems with Cordray himself taking this position that should be mentioned as well (which we have done on our blog a few times). Finally, the debate over the legality of the President's decision should not distract from the fact that the CFPB director office is a horrifying power grab that has the potential to damage the economy from financial innovation to access to credit for small businesses and households.

The Federal Reserve is Buying Euro Debt and We are All Going to Pay

Posted on December 16, 2011, 11:13am | James Groth

Two-weeks ago the Federal Reserve announced a coordinated effort by six central banks to make it cheaper to borrow dollars in emergency situations. The premium to borrow dollars overnight via foreign exchange swaps was reduced by 50 bps, and the timeframe to access this emergency cash was extended out to February, 2013.

This is old news of course, but the results of the decision are not.

The lowered rate opens up an arbitrage situation whereby a spread can be collected risk-free (barring a few low-probability outcomes). Banks and institutions in Europe as well as America and elsewhere are taking advantage of this free cash and are also exploiting it to buy en masse the debt of Spain and Italy. Essentially, the Fed, via swap lines is lending through foreign central banks to institutions and banks to immediately purchase debt, primarily that of Spain and Italy.

In essence, the Federal Reserve is buying Spanish and Italian Debt.

Not only is the manager of our sole medium of exchange risking our purchasing power to bail out the lifestyles and frivolousness of the European periphery, but they’re also bank rolling hedge funds in the process.

The announcement from the Fed came on November 30^th, but the swap lines were not accessible at the discounted rate until December 5^th, leaving two trading days for hedge funds and other large institutions with heavy cash positions to front-run sovereign debt buyers that would be making huge purchases on December 5^th. If you factor in insider trading, which for an operation like this is an absolute certainty, traders had even more opportunity to front-run. Front-running means buyers with no interest to own something, buy in front of those who are actually interested in owning, and sell to them for a profit and to the ultimate owner’s loss. For instance, I buy at $90 knowing full well that natural buyers will be coming to market in two days.  My buying drives the price up to $93 where I then sell to the natural buyers. I profit $3 from front-running, and the natural buyers lose that same $3 that they otherwise would not have had to pay had I not driven up the price. Now, magnify that $3 to a couple billion, and you can understand why hedge funds, institutions, and banks love it when the Fed gets into markets.

But there is something more inherently wrong with this situation, namely that our central bank is buying Italian and Spanish debt. The Fed will tell you of course that they are only lending to central banks, and that central banks, like the ECB, are the only counterparty. While this is true, that money is winding-up in banks all over the world, primarily in Europe, and they’re then turning around and buying dodgy debt. So should that debt plummet, like in the case of Greece over the past year, the central banks that the Fed has lent to, namely the ECB, will have to print their sovereign currency ad nauseam to come up with the dollars with which to pay us back. That would be disastrous. But it was a situation that we weren’t party to until last week.

Pundits downplayed this new Fed action on the day of its announcement, but the results of the subsequent borrowings have had significant market effects. Banks demanding dollars from the ECB through this facility came in over five times expectations at $52.3 billion. Purchases from this added liquidity brought yields on Spanish 10-year bonds down to 5.09 percent from 5.68 percent on the day of the borrowings. They had been as high as 6.7 percent when the initial front-running began.

Yields on Italy’s debt reacted the same. Italian 10-year yields fell from 6.68 percent to 5.93 percent on the day of the borrowings and had been as high as 7.3 percent. These are huge swings and they are all central bank orchestrated.

The same sovereign bond market reaction occurred this past August when the ECB stepped in through their Securities Market Program (SMP) and bought €130 billion in periphery debt. I wrote about the ridiculousness of those purchases here and here. Following the ECB action, yields plummeted much the same as they did last week, but then traded back up as the purchases leveled off. Below is a chart that shows the yields of Spanish and Italian 10-year bonds overlaid with the purchases of the SMP program and the Fed’s latest swap operations.

It is clear to see the effect these central bank actions have on bond prices and their corresponding yields, albeit artificial.

You may be thinking that this is a good thing that the yields have fallen. After all, it is rising borrowing costs (bond yields) that are causing all the pain in Europe and anything the ECB or the Fed can do to bring these costs down is good. While that may be true in the short-term, if the long-term issues of insolvency aren’t addressed, a currency crisis could ensue, and it will be much more severe and many more years longer if it is postponed through short-term liquidity injections. Ultimately, the liquidity injections may not produce any positive results save for a few months of delusion from those thinking that the problem has been solved.

Consider Greece, which back in May, 2010 had the same episode of rising bond yields. The ECB stepped in through their newly created SMP providing €70 billion to purchase the sovereign debt acting to avert what they deemed, a liquidity crisis. The below chart displays Greece’s 10-year bond yield overlaid with the SMP purchases.

It looks eerily similar to the first chart: yields are steady, yields rise, the ECB intervenes and yields plummet, yields trickle back up as the purchases level off. It is the exact same situation, at nearly the exact same yield levels, only a year earlier and a different country.  Greek yields have since skyrocketed. The country is now bankrupt.

The following chart displays the Greek 10-year yield over the past two-years, the highlighted section being the time period of the chart above.

Remember that back in May, 2010 the ECB claimed that the situation facing Greece was nothing more than a liquidity crisis and that through purchasing its bonds, the crisis could be averted. This justified their intervention. It is now clear that Greece is in fact insolvent, and its bonds reflected a solvency crisis. Under such a scenario, no matter how much money is thrown at the situation, default is inevitable. Any money invested will be lost.

Looking at the first two charts it is easy to draw parallels, and the third chart may indeed be the future facing Spain and Italy. If that should prove to be true, and the situation in Spain and Italy is a solvency crisis misdiagnosed as a liquidity crisis, the ECB and especially the Fed has no business buying their debt. It is just wasting money on an inevitable default and compounding the problems of bankruptcy, spreading the pain to millions more people than is necessary.

Americans' future now depends on the gambling of America's central bank placing bets on the probability that the lifestyles of Spaniards and Italians are conducive to paying bills and balancing a check book.

Is that a wager you would make? Doesn't matter, you already did.

To Anyone Reading About Paulson Tipping-off Goldman Sachs Hedge Fund Managers

Posted on November 29, 2011, 1:11pm | James Groth

 

Bloomberg released a piece today titled: “How Paulson Gave Hedge Funds Advance Word” which reports that former Treasury Secretary and former Goldman Sachs CEO, Hank Paulson gave nonpublic sensitive information about the pending collapse and conservatorship of Fannie Mae and Freddie Mac to a select group of hedge fund managers, many of them Goldman Sachs alumni, weeks before the event happened.

It has been widely read and hashed-out by numerous other news services. I recommend having a look.

The article is disturbing. One thing anyone reading the articles should note, however, is the mention that “there’s no evidence that [the hedge fund managers traded on the information] after the meeting; tracking firm-specific short stock sales isn’t possible using public documents.”

While it is true that this information is not public, it most certainly is attainable.

Firms trade under a specific login which tracks every trade, whether executed or not, entered on the exchange. This information is stored and used by brokerages and clearing houses for various reasons and can even be used to “break” executed trades should poor execution occur. This information can be used to determine precisely when and where and to the exact amount any firm traded in any listed security. And it most certainly can be used in this case to uncover whether the hedge fund managers capitalized on the nonpublic information provided by Paulson.

And why do we not know this information?

Because as much as Bloomberg and every other Tom, Dick, and Harry news service out there would like to furnish the information, it is not public, and therefore is not available to their inquiry. It is, however, available to the SEC. And they could have it all disseminated by tomorrow morning if they felt so inclined.

So, will that happen?

Probably not. The hedge fund managers present when Paulson was spieling out golden nuggets of trade secrets compromise The Asset Managers’ Committee established by the President’s Working Group. They are all an integral part in keeping financial information, market discipline, regulatory safeguards, and most notably, valuation within the status quo. Proof of insider trading by this group would be inconceivable. Thus, we’ll all continue to remain in the dark.

Kudos to Bloomberg, however, who was at least able to raise the question and through FOIA requests was able to obtain information shedding light on suspect behavior. It’d be nice if an agency with teeth carried-out their duty on this one.

 

Judge Forces the SEC to Actually Do its Job

Posted on November 28, 2011, 6:15pm | James Groth

 

In a previous blogpost, I wrote about how the phrase “settled without admitting or denying wrongdoing” should be the mantra of the Securities and Exchange Commission (SEC). So many traders, hedge fund managers, bankers, and corporations have avoided criminal charges by simply paying a monetary settlement to the SEC to get off scot-free and go back to working in financial markets, often times becoming multiple-repeat offenders. Most often, the settlement is a negligible slap on the wrist and does little to prevent future fraud. To many financial players and traders, the SEC is a joke, easily paid-off when they happen to catch a slip-up. The so-called top watchdog of financial markets is an embarrassment to people who trust and believe the SEC is actually protecting their interests against fraud.

The SEC recently pursued the same “settled without admitting or denying wrongdoing” settlement with Citigroup after the firm allegedly hand-picked securities to be included in a billion-dollar mortgage securities fund without telling investors, claiming that the securities were being chosen by an independent entity. Citigroup then sold those same securities short making $160 million for itself and $700 million in losses for the investors.

Citigroup and the SEC had agreed to settle for $285 million and of course neither admit nor deny wrongdoing, but federal judge, Jed Rakoff threw-out the settlement stating that the “judgment is neither fair, nor reasonable, nor adequate, nor in the public interest.”

Judge Rakoff ruled that settling without admitting or denying wrongdoing in this case creates substantial potential for future abuse. He went on to state that the SEC’s practice of allowing such settlements without establishing facts of wrongdoing is a disservice to the public interest. The ruling is a wake-up call to firms and individuals promulgating fraud and to the SEC who is complicit in enabling fraud to occur.

From the ruling:

“Purely private parties can settle a case without ever agreeing on the facts, for all that is required is that a plaintiff dismiss his complaint. But when a public agency asks a court to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt, the court, and the public, need some knowledge of what the underlying facts are: for otherwise, the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importance."

Hopefully this becomes the standard and forces the SEC into actually seeking the facts of fraud to prevent future abuses instead of simply agreeing upon a fine that merely funds the SEC’s own operation of pretending to be an enforcer of law. There have been far too many fraudulent practices that have gone unpunished. The public deserves justice and the truth, not widespread abuse by bankers and their regulators.

Judge Rakoff writes in the ruling:

“An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous. In any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth… [The SEC] has a duty, inherent in its statutory mission, to see that the truth emerges.”

 

Justice Department Investigates Banks – a Bit Off and a Little Late

Posted on November 28, 2011, 1:26pm | James Groth

Last week, the Justice department announced it will be investigating banks and their trade associations regarding the increases in consumer fees imposed by banks for using debit cards. House democrats asked the Attorney General’s office to investigate whether banks and their trade groups violated anti-trust law by colluding on whether to impose fees in response to the Durbin Amendment which placed a cap on the amount of money banks charge retailers for accepting debit card transactions.

Earlier this month, Anthony Randazzo and I wrote an op-ed describing the unintended consequences of the Durbin Amendment which led banks to impose the array of fees now subject to the Justice Department investigation. We noted how as a result of the amendment bank customers will now be subject to a plethora of non-transparent fees totaling around $200 per year depending on the customer’s bank. But far from a quasi-monopoly of colluding banksters, institutions like USAA have also raised costs to consumers in direct response to the Durbin Amendment.

Bloomberg finance analyst, Cady North, conducted a study on the Durbin Amendment titled “Business Impact of the Dodd-Frank Debit Fee Cap” and in an interview summed-up her findings with the following:

“The banks are…still going to find ways to make-up that revenue. The networks… are seeing some revenue opportunities, and even though the retailers might be seeing some benefits, [smaller retailers] like small coffee shops and…convenience stores...might be actually losing a lot of money as a result of [the Durbin Amendment].”

Basically, big box retailers like Wal-Mart and Home Depot stand to make hundreds-of-millions-of-dollars while smaller mom-and-pop-shops lose money and consumers lose money to banks.

However, house democrats hope to change that last unintended consequence with the help of the Justice Department. But the problem is that it is misdirected, and extremely late.

If representatives truly wanted to help consumers, they would have investigated whether big banks were colluding through monopoly power to charge exorbitant fees to retailers prior to the passage of the Durbin Amendment. Should such an investigation prove this to be true, the bank’s practice of charging high fees could be dealt with through the legal process under existing anti-trust law. Should the investigation prove the fees to be a fair business practice absent collusion and monopolistic bullying, then simply it is the cost of doing business, and we as consumers must take responsibility to choose our banks and retailers wisely. But this wasn’t done.

Instead we have in place a piece of bad legislation with the unintended consequences of raising costs to the consumer, incenting further use of credit (as opposed to cash or debit), lowering small retail owners profit margins, transferring profits to huge corporations like Wal-Mart, and now an investigation into whether banks acted lawfully to legislation that resulted from a powerful retail lobby and crony capitalism.

If banks are infringing upon consumers rights through collusion and monopoly power, they should be dealt with through a legal process already in place, otherwise let the market determine whether transaction costs are too high. Government has failed two-fold by not investigating whether banks were violating anti-trust law, and again by passing damaging legislation as a result of their ineptitude. American consumers and small-retail businesses are now paying for their failures.

Cheap Fed Cash for Banks, Lending as a Last Resort, OWS and the Tea Party

Posted on November 28, 2011, 12:17pm | Anthony Randazzo

The Drudge Report set one of the main topics for TV and radio shows today with its headline noting the $7.77 trillion that the Federal Reserve secretly lent to the banks during the financial crisis that was metastasizing in 2008 and early 2009. As we've long discussed on this blog and elsewhere at Reason, the Fed was the main bailout source for the banks by creating unlimited lines of credit for banks to tap and keep themselves afloat. It calls into question what the point of TARP was with all of this Fed lending going on (hint: Paulson only could think in terms of stocks and the confidence that drives the marketplace), but the reality is that without Bernanke and the Fed stepping in the way they did, the financial system would not look the same as it does today. Some will argue it would be worse. I'd argue it would be better.

At the very least, there would be fewer crony capitalists about. I'll continue to fight against the idea that Washington can regulate the soundness of the financial system through something like Dodd-Frank, but the $13 billion that Bloomberg reports the banking system was able to generate from the loans that were supposedly needed to keep the banking system from collapsing is not profit generated from a free market. And that should not be defended. 

The OWS crowd is right on target in complaining about illicit gains leveraged the backs of taxpayers. It makes sense that commentators would argue, why should the banks get this special treatment? Where is the access to virtually free money for homeowners to pay their bills and avoid foreclosure? The problem is that the banks shouldn't have been given a lifeline and neither should homeowners. We don't want to become a bailout society. The desire for a "main street bailout" looks like a pitch for "fairness" but unfortunately it is more out of a sense of envy than anything else—almost like Scott Peterson being envious that O.J. got off with the help of some shrinking gloves.

How about no one gets a bailout? An era of responsibility?

The justification for the Fed stepping in with its trillions in liquidity stems from a misperception on what the role of a central bank is supposed to be as "lender of last resort." The LLR idea was developed by Henry Thornton and Walter Bagehot in 19th Century England, and the thought at the time was for an institution with monetary authority to be able to lend freely at a high interest rate to creditworthy borrowers who had good collateral but were unable to find access to needed liquidity for an abnormal reason. The very idea of an LLR assumes market failure, though when it has been needed in the past the supposed market failure can be traced back to a government failure. But the key point is to creditworthy borrowers, with a penalty rate, and demanding of good collateral. 

The lender of last resort is not supposed to rain cash down on anyone claiming to be a bank, for virtually free, and without getting much of anything in return. In fact, the Fed has gone a step beyond and just straight bought the crappy collateral from the banks in separate actions that they should have been avoiding even lending against.

The whole LLR role in the financial system has become completely screwed up. And the result is over $7 trillion flowing to broken banks that should have been liquidated now (with their deposits scattered among a handful of smaller banks as individuals seek alternative places to keep their money). The result is financial institutions banking a ridiculous carry trade. And then as a result the banking system starts to look healthier, executives get bonus pay, and the masses get enraged.

From this perspective it is not the bonuses—it is the Fed. It is the government that is so desperate to avoid change that they perpetuate the system and the guys who have screwed up and as a result undeserving compensation gets dished out. 

You can see how capping executive pay is not going to solve this problem. Neither will a Volcker Rule. If Occupy Wall Street wants to screw over the banks they hate so much they should push to cut off the lifeline to Washington. If the Tea Party wants to push for real change it should reject conservative talking points that just defend the financial system without recognizing the crony capitalism that has made Wall Street what it is today.

See the whole Bloomberg story here.

We Don't Have All the Answers: A Regulation Warning

Posted on November 15, 2011, 2:09pm | Anthony Randazzo

Last week, I attend a conference co-hosted by the Chicago Federal Reserve Bank and the European Central Bank. The topic was the role of central banks in financial stability, and many of the papers presented were focused on how to improve macroprudential regulation. I was struck by the confidence of the presenters (there were roughly 40 or so 15 to 20 minute presentations) in their belief that "now we've figured it out" and can design the right regulations to create financial stability. One—just one—of the academics suggested that instead of talking about how we are preventing problems in the future were should figure out the problems of today. And a few expressed some skepticism in the ideas others put forth. But no one stood back and said, maybe it is impossible for us to now have all the answers, just a few years after the crisis.

One of the ideas behind Dodd-Frank was that by granting regulators more powers they could prevent problems at financial institutions. The general consensus is that the legislation really didn't end the too-big-to-fail problem. But behind that, the law was essentially backward looking. It put in place a lot of rules that may or may not have prevented the financial crisis in 2007-2008, but that was in the past. The next crisis will be of a different character, come from a different place, and quite possibly evolve out of the regulations recently promulgated. 

The failure of MF Global is evidence of this. A key part of the story of MF Global's collapse is that they did a terrible job tracking their own finances. In fact, they lost hundreds of millions of client cash not to bad trades but in bad book keeping. Most of the money has been found, but it has let to the CFTC taking industry wide action. Dealbook reported last week:

Federal regulators have ordered an audit of every American futures trading firm to verify that customer money is protected, a move that comes after roughly $600 million in client funds were discovered to be missing from MF Global, the bankrupt brokerage firm once run by Jon S. Corzine.

The Commodity Futures Trading Commission, the federal regulator searching for the missing money at MF Global, will audit many of the nation’s largest futures commission merchants, according to a person briefed on the decision. Exchanges like the CME Group will examine smaller firms to ensure they are keeping customer money separate from company money, a fundamental rule on Wall Street.

What is interesting about this is that there never was a thought given to verifying that futures traders were keeping track of their customer's cash. In all the backward looking regulation, this had never come up. Because it was a future problem.

Now, we could argue about whether or not the CFTC needs to be checking in on firm's ability to track its own cash. If they fail to do so there is some liability on the shoulders of investors in picking the right place to keep money, and there will be legal liability toward any firm that leverages its client money for trading its own book. But the point here is that the CFTC didn't think to regulate this until it became a possible problem.

This will always be the nature of depending on regulation. That is not to say there should be no rules. That doesn't even necessarily say that Dodd-Frank's rules were bad (though they were). But it does make a point that rises above partisan politics—depending on backward looking regulation is not going to lead to financial stability.

Every brilliant academic who presented at the Chicago Fed-ECB conference should be able to discern this. Though at at certain point, your own brilliance may lead you to believe you can John Nash the world and see the matrix floating by. In this case, understanding the Hayekian knowledge problem becomes critical to recognizing the limitations of humanity and the value of accepting a more market driven world of failure and success that depends on personal liability and not societal supports to achieve a false sense of stability. 

 

Durbin and Wal-Mart vs. Consumers

Posted on November 10, 2011, 5:21am | Anthony Randazzo

If you bank at USAA you have not seen your checking account fee increase—but you still have lost an average of $84 a year from shut down rewards programs. That's the equivalent of a $7/mo fee. 

This is just one of the things that Reason's James Groth points out in an op-ed published in Minyanville yesterday:

Instituting monthly fees on customers making purchases with debit cards—which would be a straightforward way to fund the provision of debit card services—has resulted in public outcry and a substantial outflow of customer deposit accounts forcing financial institutions to change tact and find other sources of revenue. Banks are planning to charge checking account fees for customers who do not meet minimum balance requirements, or who do not exclusively bank online and use online bill pay.

TD Bank (TD) has already raised fees on a host of services like wire transfers and money orders, and it has also created a $9 fee charging customers for making more than six withdrawals in a billing period. Some banks are exploring eliminating all overdraft and non-sufficient fund fee reimbursements. Banks may also place a $50 or $100 cap on the amount customers can charge per debit transaction.

Despite whether or not these fees are fair business decisions, they are not necessarily the actions of greedy bankers squeezing what they can from their customers. Even USAA, a part co-operative serving primarily America’s U.S. military personnel, veterans, and U.S. military family members, is cancelling programs as a direct result of the Durbin Amendment costing its banking customers an estimated $84 per year.

The Durbin Amendment will cost customers banking with Bank of America, JPMorgan Chase, and Wells Fargo close to $200 per year depending on the mix of fees they choose to adopt.