Financial Russian Roulette
Will the U.S. financial system collapse today, or maybe over the next few days? I don’t think so — but I’m nowhere near certain. You see, Lehman Brothers, a major investment bank, is apparently about to go under. And nobody knows what will happen next.
To understand the problem, you need to know that the old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term clients, has largely vanished, replaced by what is widely called the “shadow banking system.” Depository banks, the guys in the marble buildings, now play only a minor role in channeling funds from savers to borrowers; most of the business of finance is carried out through complex deals arranged by “nondepository” institutions, institutions like the late lamented Bear Stearns — and Lehman.
The new system was supposed to do a better job of spreading and reducing risk. But in the aftermath of the housing bust and the resulting mortgage crisis, it seems apparent that risk wasn’t so much reduced as hidden: all too many investors had no idea how exposed they were.
And as the unknown unknowns have turned into known unknowns, the system has been experiencing postmodern bank runs. These don’t look like the old-fashioned version: with few exceptions, we’re not talking about mobs of distraught depositors pounding on closed bank doors. Instead, we’re talking about frantic phone calls and mouse clicks, as financial players pull credit lines and try to unwind counterparty risk. But the economic effects — a freezing up of credit, a downward spiral in asset values — are the same as those of the great bank runs of the 1930s.
And here’s the thing: The defenses set up to prevent a return of those bank runs, mainly deposit insurance and access to credit lines with the Federal Reserve, only protect the guys in the marble buildings, who aren’t at the heart of the current crisis. That creates the real possibility that 2008 could be 1931 revisited.
Now, policy makers are aware of the risks — before he was given responsibility for saving the world, Ben Bernanke was one of our leading experts on the economics of the Great Depression. So over the past year the Fed and the Treasury have orchestrated a series of ad hoc rescue plans. Special credit lines with unpronounceable acronyms were made available to nondepository institutions. The Fed and the Treasury brokered a deal that protected Bear’s counterparties — those on the other side of its deals — though not its stockholders. And just last week the Treasury seized control of Fannie Mae and Freddie Mac, the giant government-sponsored mortgage lenders.
But the consequences of those rescues are making officials nervous. For one thing, they’re taking big risks with taxpayer money. For example, today much of the Fed’s portfolio is tied up in loans backed by dubious collateral. Also, officials are worried that their rescue efforts will encourage even more risky behavior in the future. After all, it’s starting to look as if the rule is heads you win, tails the taxpayers lose.
Which brings us to Lehman, which has suffered large real-estate-related losses, and faces a crisis of confidence. Like many financial institutions, Lehman has a huge balance sheet — it owes vast sums, and is owed vast sums in return. Trying to liquidate that balance sheet quickly could lead to panic across the financial system. That’s why government officials and private bankers have spent the weekend huddled at the New York Fed, trying to put together a deal that would save Lehman, or at least let it fail more slowly.
But Henry Paulson, the Treasury secretary, was adamant that he wouldn’t sweeten the deal by putting more public funds on the line. Many people thought he was bluffing. I was all ready to start today’s column, “When life hands you Lehman, make Lehman aid.” But there was no aid, and apparently no deal. Mr. Paulson seems to be betting that the financial system — bolstered, it must be said, by those special credit lines — can handle the shock of a Lehman failure. We’ll find out soon whether he was brave or foolish.
The real answer to the current problem would, of course, have been to take preventive action before we reached this point. Even leaving aside the obvious need to regulate the shadow banking system — if institutions need to be rescued like banks, they should be regulated like banks — why were we so unprepared for this latest shock? When Bear went under, many people talked about the need for a mechanism for “orderly liquidation” of failing investment banks. Well, that was six months ago. Where’s the mechanism?
And so here we are, with Mr. Paulson apparently feeling that playing Russian roulette with the U.S. financial system was his best option. Yikes.
Markets sank in Europe and Asia today, stock index futures slipped sharply on Wall Street, and the dollar plunged as two giant investment banks, Lehman Brothers and Merrill Lynch, collapsed over the weekend. Compounding the financial uncertainty, insurance giant A.I.G. "sought a $40 billion lifeline from the Federal Reserve, without which the company may have only days to survive."
Former Fed chairman Alan Greenspan said the U.S. credit squeeze has brought on a "once-in-a-century" financial crisis that is likely to claim more big firms before it eases. "Indeed, it will continue to be a corrosive force until the price of homes in the United States stabilizes," Greenspan said.
A new poll released by the AP and National Constitution Center finds that "Americans strongly oppose giving the president more power at the expense of Congress or the courts, even to enhance national security or the economy." Two-thirds of Americans oppose altering the balance of power to strengthen the presidency.
The government announced yesterday that "it would not allow Fannie Mae and Freddie Mac to pay their departing chief executives the separation payments, known as 'golden parachutes.'" The decision deprives the departing chiefs of Fannie and Freddie of $9.8 million and $14.9 million respectively.
by Faiz Shakir, Amanda Terkel, Satyam Khanna, Matt Corley, Benjamin Armbruster, Ali Frick, and Ryan Powers
McCain-onomics
Sen. John McCain (R-AZ) has spent much of his general election campaign for president trying to distance himself from President Bush's failed policies -- even though the policies he has outlined and would pursue as president mirror those of the last eight years. McCain's strategy so far has been to make the public forget he is offering Bush's policies. During the Republican National Convention earlier this month, McCain and his fellow conservatives seemingly refused to acknowledge that the current administration even exists: Bush's name was mentioned once while Vice President Dick Cheney's name was not mentioned at all. Convention speakers also ignored many key issues that face Americans today, such as health care, environment, and the economy. Yet at times, McCain's surrogates will let the truth slip out. In June, Sen. Lindsey Graham (R-SC) admitted that McCain's economic policies would "absolutely" be an "enhancement" of Bush's. He's right. McCain's economic policies are rooted in the same supply-side economic theories that give huge tax cuts to the rich and the most profitable corporations, which will ultimately expand the already ballooning federal deficit. Indeed, as New York Times columnist and Princeton University economics professor Paul Krugman noted, McCain's economic proposals are "Bush made permanent" and "would leave the federal government with far too little revenue to cover its expenses."
THE WEALTHY WILL CASH IN: If elected president, McCain plans to double down on Bush's corporate and individual tax cuts. His plan calls for reducing the corporate tax rate from 35 percent to 25 percent, a plan that would save corporations $175 billion per year, with $45 billion going to America's 200 largest companies as identified by Fortune Magazine. The five largest U.S. oil companies would save a grand total of $3.8 billion per year. The wealthiest Americans would also cash in. McCain's tax plan will increase after-tax income of the richest 3.4 percent by more than twice the average for all households -- and offer no benefit to the poorest taxpayers and minimal savings for the middle class. At the same time, McCain has not offered any specifics on how he would pay for these massive cuts. In fact, McCain's plan would produce the highest federal deficit in 25 years. After inheriting Bush's $407 billion deficit, yearly deficits under McCain would increase sharply, beginning with at least $505 billion in FY2009.
THE FLAWS OF SUPPLY-SIDE ECONOMICS: Like Bush -- and President Reagan before him -- McCain is fully embracing supply-side economics, lowering tax rates to promote economic activity which, in theory, lead to additional government revenue. But a new report from the Center for American Progress and the Economic Policy Institute has analyzed the two "supply-side eras" in U.S. history -- 1981 to 1993 and 2001 to present -- and concluded that "the results have been meager." The report found that after tax increases in 1993, real investment growth was much higher than after the tax cuts of 1981 and 2001 and "economic growth as measured by real U.S. gross domestic product was stronger following the tax increases of 1993 than in the two supply-side eras." Real median household income "was greatest after the 1993 tax increases, at 2.0 percent annually compared to 1.4 percent after 1981 and 0.3 percent after 2001." Wages and employment also rose higher after 1993 as compared to the two supply-side eras. And in contrast to record deficits that resulted from the two supply-side eras, between 1993 and 1999, the United States"went from a federal deficit of 3.9 percent of GDP to a surplus of 1.4 percent." Even Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have said that tax cuts do not offset revenue losses.
GREENSPAN WEIGHS IN: Former Fed Chairman Alan Greenspan said that the current downturn in the economy is "probably a once in a century type of event," one that is the worst he has seen in his career "by far." Indeed, just yesterday, Merrill Lynch agreed to sell itself to Bank of America "for roughly $50 billion to avert a deepening financial crisis, while another prominent securities firm, Lehman Brothers, filed for bankruptcy protection and hurtled toward liquidation after it failed to find a buyer." But Greenspan also addressed McCain's $3.3 trillion tax cuts, telling Bloomberg news last week that the country cannot afford the cuts "unless we cut spending." "I'm not in favor of financing tax cuts with borrowed money," Greenspan said. Perhaps McCain will take Greenspan's advice. While McCain has acknowledged that "issue of economics is not something I've understood as well as I should," he has also added the caveat: "I've got Greenspan's book."
McCain’s Record On Economic Reform: ‘Zero’
A new ad released this morning by the McCain campaign states, “Our economy in crisis. Only proven reformers John McCain and Sarah Palin can fix it.” In a statement today, McCain said he will “replace the outdated and ineffective patchwork quilt of regulatory oversight in Washington” and bring “accountability to Wall Street.” That promise rings hollow considering he has the former lobbyists of AIG, Merrill Lynch, Lehman Brothers, and Bank of America on his campaign staff.
On Bloomberg Television this weekend, House Financial Services Committee Chairman Barney Frank noted that, as a leader in the Senate Republican caucus, McCain did nothing for years to deliver reform in the face an impending credit crisis:
So here’s the record – 12 years of Republicans, including John McCain being a committee chairman for much of that period. Zero – zero enactment of any reform. Democrats take power, and in a year and a half, we have passed a bill that did everything the administration asked for, in terms of enhancing the regulatory structure.
Watch it:
Years of right-wing economic policies have created this moment of financial crisis. The mortgage bubble resulted when Fed chief Alan Greenspan kept interest rates at historic lows, and the government failed to regulate questionable practices in the financial sector.
This fact was underscored recently by Republican Mike Oxley, the former chairman of the House Financial Services Committee. Oxley noted that the House passed a bill in 2005 that could well have prevented the current crisis by issuing stronger regulations of Fannie Mae and Freddie Mac:
“All the handwringing and bedwetting is going on without remembering how the House stepped up on this,” he says. “What did we get from the White House? We got a one-finger salute.” […]
“We missed a golden opportunity that would have avoided a lot of the problems we’re facing now, if we hadn’t had such a firm ideological position at the White House and the Treasury and the Fed,” Mr Oxley says.
Oxley recalls that the bipartisan legislation “faced hostility from the Bush administration,” but also “lacked a champion in the Senate.”
Big Banks Go Bust: Time to Reform Wall Street
By Dean Baker
September 15th, 2008 - 10:45am ET
With the demise of Fannie Mae, Freddie Mac, IndyMac, Bear Stearns and now Lehman Brothers, we’ve been treated to the failure of more major financial firms than during any year since the Great Depression. The sight of rich bankers getting the boot might be lots of fun if it were just a spectator sport. Unfortunately, we are in the game with these clowns.
As a result of their incompetence, irresponsibility and greed, the housing bubble was allowed to grow to dangerous proportions. Its collapse threw the economy into recession, putting millions of people out of work and lowering the wages of those who still have their jobs. The plunge in house prices has destroyed much of the life savings for tens of millions of people nearing retirement.
Meanwhile, the bankers who messed up and destroyed the companies who hired them are still multimillionaires. Most of them are still in their old jobs getting multimillion-dollar pay packages. This is a sector that badly cries out for reform and there is no better time than now to put it into place.
The first target for reform should be the outrageous salaries drawn by the top executives at financial firms. The crew that lost tens of billions at Citigroup, Merrill Lynch and the rest have received tens of millions, possibly even hundreds of millions, in compensation for their “work” over the last few years.
There is a general problem in corporate America of stockholders being unable to effectively organize to rein in top management. This problem is most serious in the financial industry.
Thankfully, the credit crisis gives us the tools we need to rein in executive pay. Currently, the major surviving investment banks (e.g. Merrill Lynch, Morgan Stanley, Goldman Sachs) are operating on life support. They are drawing money at below market interest rates from the Federal Reserve Board’s discount window. This privilege (for which they pay nothing) can easily be worth billions of dollars a year.
These banks are also operating with an explicit guarantee from Fed Chairman Ben Bernanke to their creditors that he will honor their loans in the event that an investment bank, like Bear Stearns, goes belly up. This guarantee is enormously valuable. Investors who make loans to Merrill Lynch or Morgan Stanley don’t have to worry about the health of these companies because Bernanke has said that, if necessary, he will use public money to pay them back.
While we don’t want a chain reaction of banking collapses on Wall Street, the public should get something in exchange for Bernanke’s generosity. Specifically, he can demand a cap on executive compensation (all compensation) of $2 million a year, in exchange for getting bailed out. For any bank that is not on board, Bernanke could make an explicit promise to their creditors – if the bank goes under, you will get zero from the Fed.
This can be an effective way to restore sanity to the salaries paid on Wall Street. And, this can be a good example for setting executive pay more generally. Any time a company comes to the public for a handout, like tax breaks for oil companies or low-interest loans for auto companies, the $2 million cap on all compensation goes into effect.
This is important directly because much of the country’s wealth has been steered into these folks’ pockets, but also because the outrageous compensation packages on Wall Street distorted pay structures throughout the economy. Presidents of universities often get over $1 million a year, and even top executives at private charities can often earn near $1 million a year. These salaries seem low when compared to their counterparts in the corporate world, but they are outrageous when compared to the pay checks of typical workers.
Of course we must go further in fixing the financial sector—most importantly by downsizing it. The financial sector accounted for more than 30 percent of corporate profits in 2004. Back in the 1950s and 1960s, the country’s period of most rapid growth, the financial sector accounted for less than 10 percent of corporate profit.
The financial sector performs an incredibly important function in allocating savings to those who want to invest in businesses, buy homes, or borrow money for other purposes. But shuffling money is not an end in itself. The explosion of the financial sector over the last three decades has led to a proliferation of complex financial instruments, many of which are not even understood by the companies who sell them, as we have painfully discovered.
The best way to bring the sector into line is with a modest financial transactions tax. Such taxes have long existed in other countries. For example, the United Kingdom charges a tax of 0.25 percent on the purchase or sale of share of stock. This is not a big deal to someone who holds their shares for ten years, but it could be a considerable cost for the folks who buy stocks in the morning that they sell in the afternoon.
Comparable taxes on the transfer of all financial instruments (e.g. options, futures, credit default swaps, etc.) could go a long way in reducing speculation and the volume of trading in financial markets. Such a tax could also raise an enormous amount of money—easily more than $100 billion a year. This would go a long way toward funding national health care insurance or a major green infrastructure project.
And, this tax would be hugely progressive. Middle-income shareholders might take a small hit; but it would be comparable to raising the capital gains tax rate back to 20 percent, where it was before it was cut to 15 percent in 2003. The real hit would be on the big speculators and the Wall Street boys, the folks who gave us the housing crisis. Given what the Wall Street crew has done for us, this is change that we can believe in.
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