What happened to the global economy and what we can do about it
Month: April 2010
By Peter Boone and Simon Johnson
The latest developments from Europe – including Greece appealing for an IMF program today – may well be a watershed, but if so, it is not a good one. The key event yesterday was that the yield on all the debt of weak eurozone governments widened while German yields fell. The spreads show all you need to know: a very clear and large contagion risk. Continue reading “Greece, The IMF, And What Comes Next”
By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown
The ideology of unfettered finance is crumbling. Whatever you think of the merits of the Goldman case from a legal or short-term perspective, the SEC’s allegation – and Goldman’s response – have further moved the mainstream consensus away from “finance is generally good” to “big banks are frequently scary.”
Senator Ted Kaufman should get a great deal of credit for his well timed charge on this issue – as I argue in BusinessWeek/Bloomberg. But Lloyd Blankfein also gets an inadvertent assist, quoted in the Financial Times yesterday as saying that the SEC case against Goldman would “hurt America.”
Mr. Blankfein is starting to sound – and act – a lot like Nicolas Biddle, head of the Second Bank of the United States (by far the most powerful commercial bank of the day), during his confrontation with President Andrew Jackson in the early 1830s. Continue reading “The Consensus on Big Banks Starts To Move”
By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover And The Next Financial Meltdown
Update: The Progressive Change Campaign Committee has a petition that takes you to a page with your senators’ names and phone numbers, as well as a script to use when calling them.
The president’s rhetoric today at Cooper Union was impressive and his body language indicates a major shift in administration attitudes towards the big banks over the past year. This is commendable.
But there is still the awkward question of legislation that would actually reduce the political power of big banks – and make our financial system significantly safer. The latest indications from the Senate are that there will be some sort of “Dodd minus” compromise bill brought to the floor early next week. The Republicans have substantially backed down from Senator McConnell’s “hell, no” position of last week because the polling is crystal clear: Anyone perceived as opposed financial reform will lose badly in November.
But the Democratic leadership is not seizing on this advantage and on the opportunity presented by the SEC case against Goldman Sachs – key figures in the Democratic establishments are too worried about upsetting financial sector donors. As a result, come November, independents will view the Democrats with scorn, while the Democratic base will be far from energized; you do the math.
What can you do? What makes sense in both economic and political terms? Continue reading “Make The Call Or Get Out Of The Booth: After The President’s “Wall Street” Speech”
By Simon Johnson, co-author of 13 Bankers.
On Wednesday, Senators Sherrod Brown and Ted Kaufman unveiled a “SAFE banking Act” with a clear and powerful purpose: Break up the big banks.
The proposal places hard leverage and size caps on financial institutions. It is well crafted, based on a great deal of hard thinking, and — as reported on the front page of The New York Times this week — the issue has the potential to draw a considerable amount of support.
The idea is simple, in the sense that the largest six banks in the American economy are currently “too big to fail” in the eyes of the credit market (and presumably in the leading minds the Obama administration — which saved all the big banks, without conditions, in March-April 2009). The bill put forward by Senator Christopher J. Dodd, the chairman of the Banking Committee, has some sensible proposals — and is definitely not an approach that supports “bailouts” — but it does not really confront the problem of the half-dozen megabanks.
In the American political system — where the power of major banks is now so manifest — there is no way to significantly reduce the risks posed by these banks unless they are broken up. Continue reading “The SAFE Banking Act: Break Them Up”
By James Kwak
First Bill Clinton said he got bad advice from Robert Rubin on derivatives. Then a Clinton adviser issued a statement essentially taking it back and blaming Alan Greenspan. (Jennifer Taub discussed some of the substantive issues on this blog.) Dan Froomkin asked Rubin, who said, “I thought we should regulate derivatives; I thought so when I was at Goldman Sachs and I thought so afterwards.” But Froomkin points out that Rubin was part of the team that suppressed Brooksley Born’s attempt to regulate derivatives back in 1998.
Brad DeLong defends Rubin, although it seems like a somewhat lukewarm defense. DeLong’s point #3 is: “Brooksley Born and her organization are the wrong people to regulate derivatives.” (That’s a statement of Rubin”s thinking at the time.) Norman Carleton, a Treasury official at the time, also defends Rubin with two posts on his blog that spell out DeLong’s point #3. In the first post, he says that Rubin favored regulation but was concerned with giving the CFTC jurisdiction over the OTC derivatives market. In the second, he explains the issue (legal certainty of existing contracts, something I don’t really want to get into here, so go read the argument there) and concludes with this logically plausible but somewhat bizarre argument:
“Rubin had proposed to Born that, instead of the CFTC asking questions about the need for regulation of the OTC derivatives market, the President’s Working Group on Financial Markets issue the questions. Born point blank refused this suggestion, thus pushing Rubin into Greenspan’s camp, much to the relief of ISDA and other Wall Street groups lobbying on this issue. They knew they had a problem with Rubin.
“Brooksley Born was so sure she was right in her legal position that she could not compromise in face of the practical and political realities. While, not to make too fine a point about it, she has been proven right and Greenspan wrong about the dangers of the OTC derivatives market, Greenspan was the better politician. History might have been different if Born had agreed to Rubin’s suggestion.”
Continue reading “What Did Robert Rubin Think About Derivatives?”
By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown
On Thursday, President Obama will give one of the defining speeches of his presidency. Most presidents are remembered for only 2 or 3 policies or events during their tenure. The SEC case against Goldman Sachs means, like it or not, the legacy of this administration is wrapped up with the outcome of this and related cases.
The president is apparently lining up to give a fairly conventional “support the Dodd bill” speech. This would be major miscalculation.
The Democrats are afraid that if they truly take on the big banks, they will lose campaign contributions and be placed a major disadvantage for November 2010 and 2012 – “don’t push it too far” is the message from the White House to the Senate. But this just shows the White House has not fully comprehended the modern nature of banking. Continue reading “What Should The President Say On Thursday?”
By James Kwak
Actually, two things, both by Steve Randy Waldman.
Part of Goldman’s defense is that it was in the nature of CDOs for there to be a long side and a short side, and the investors on the long side (the ones who bought the bonds issued by the CDO) must have known that there was a short side, and hence there was no need to disclose Paulson’s involvement. Waldman completely dismantles this argument, starting with a point so simple that most of us missed it: a CDO is just a way of repackaging other bonds (residential mortgage-backed securities, in this sense), so it doesn’t necessarily have a short investor any more than a simple corporate bond or a share of stock does. Since a synthetic CDO by construction mimics the characteristics of a non-synthetic CDO, the same thing holds. (While the credit default swaps that go into constructing the synthetic CDO have long and short sides, the CDO itself doesn’t have to.) Here’s the conclusion:
“Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading ‘against’ short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors.”
Waldman follows this up with an analysis of the premium that Goldman extracted from the buy-side investors and transferred to Paulson (in exchange for its own fee). The point here is that Goldman could have simply put Paulson and the buy-side investors together and had Paulson buy CDS on RMBS directly — but that would have affected the price of the deal, because Paulson wanted to take a big short position. So instead, they created the CDO (a new entity) and then drummed up buyers for it, in order to avoid moving the market against Paulson. The advantage of thinking about it this way is it shows what the function of a market maker is and how that differs from the role Goldman played in this transaction.
The posts are long, so sit back and enjoy.
Update: Nemo points out that I misinterpreted Waldman’s post, and Nemo is right, although I think I got the substance of Waldman’s point right. Here is what Waldman says:
“There is always a payer and a payee, and the payee is ‘long’ certain states of the world while the payer is short. When you buy a share of IBM, you are long IBM and the firm itself has a short position. Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not. There are many, many occasions when the interests of long investors and the interests of short investors are fully aligned. When IBM issues new shares, all of its stakeholders — preexisting shareholders, managers, employees — hope that IBM will succeed, and may have no disagreement whatsoever on its prospects. . . . The existence of a long side and a short side need imply no disagreement whatsoever.”
So I was clearly wrong when I said, “a CDO is just a way of repackaging other bonds (residential mortgage-backed securities, in this sense), so it doesn’t necessarily have a short investor any more than a simple corporate bond or a share of stock does.”
But — and I don’t think I’m engaging in sophistry here — Waldman’s underlying point is that even though there is a short position, that doesn’t mean that the long and short investors have diametrically opposed interests. That’s true of stocks, and it’s also true of CDOs. And so it’s disingenuous of Goldman to imply that buyers of any CDO always know that there is someone who is actively betting on it to go down in value.
The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here). Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.
Considering that much of the disastrous deregulation of the U.S. financial system occurred on President Bill Clinton’s watch, I was encouraged by his televised confessional Sunday. He admitted to Jake Tapper that he was led astray by two of his secretaries of the treasury, Robert Rubin and Lawrence Summers.
What an important and timely revelation. Admitting we have a problem is the first step to recovery. With financial rehab next up on the Senate’s agenda, it’s useful that someone is discrediting those who persist in promoting failed ideas. What to do about the $450 trillion (notional) over-the-counter (OTC) derivatives market will be at the top of the agenda. This is about big money. Really big. Industry began lobbying last year to protect the annual $35 billion haul that just five US banks bring in trading derivative contracts.
Reform ideas range from the most sensible recommendation by Professor Lynn Stout (return to a regime where naked credit default swaps are not enforceable), to Senator Blanche Lincoln’s very strong amendment (prohibiting the banks that have access to the Fed’s discount window from trading derivatives), to the necessary but insufficient (mandating all standard derivatives be cleared on exchanges and requiring collateral to be posted), to the weak (the current Senate bill, rife with exceptions).
Remember, this market includes potent credit default swaps, a key ingredient to the crisis. The existence of this $60 trillion (now $45 trillion) notional value market, protecting and connecting counterparties across the system, led to a $180 billion taxpapayer-funded bailout of AIG. And, as we have just learned, CDS played a central role inside the synthetic Abacus 2007-AC1 vehicle, a device that helped Goldman Sachs rob purchasers to pay Paulson.
Yet, in spite of the power of Clinton’s admission, or perhaps because of it, just after the interview with Tapper, Clinton counselor Doug Band swiftly dispatched a disclaimer. In a moment of blatant grade inflation, Band said that Clinton believed Rubin and Summers provided “excellent advice on the economy and the financial system.”
By Simon Johnson
This weekend Jamie Dimon (head of JP Morgan Chase) told the German newspaper Welt am Sonntag that he needs “better access for bankers to politicians” and that the banking industry could do with more influence on politicians. He also mentioned the need for a forum where banks can “demonstrate their arguments to politicians and supply them with the right facts” (that wording is from Reuters’ summary).
We would welcome a debate with Mr. Dimon in any forum, preferably in public and with TV cameras present. We have previously extended a similar invitation to any bank executives – including but not limited to the 13 Bankers in the title of our book.
One of the 13 appeared in an off-the-record panel last summer with me; it’s not clear that he would agree to do the same again today. One other leading person from the financial sector – although not a current top executive – has expressed interest in a public debate; we agreed and now the ball is in his court. Continue reading “Jamie Dimon Should Debate Us”
By Simon Johnson, co-author of 13 Bankers, as discussed on the Today show this morning with Matt Lauer and Erin Burnett
The biggest banks in the United States have become too big – from a social perspective. There are obviously private benefits to running banks with between $1 trillion and $2.5 trillion in total assets (as reflected in today’s earnings report), but there are three major social costs that the case of Goldman Sachs now makes quite clear.
1) The megabanks have little incentive to behave well, in terms of obeying the law. There is fraud at the heart of Wall Street, but these banks have deep pockets and suing them is a daunting task – as the SEC is about to find out. The complexity of their transactions serves as an effective shield; good luck explaining to a jury exactly how fraud was perpetrated. These banks have powerful friends in high places – including President Obama who still apparently thinks Lloyd Blankfein is a “savvy businessman”; and Treasury Secretary Geithner, who is ever deferential.
2) The people who run big banks brutally crush regular people and their families on a routine basis. You can see this in two dimensions
A. They are not inclined to treat their customers properly. They have market power in particular segments (e.g., new issues or specific over-the-counter derivatives) and there are significant barriers to entry, so while behaving badly undermines the value of the franchise, it does not destroy the business. Talk to some Goldman customers (off-the-record; they don’t want to bite the hand that hurts them). Lloyd Blankfein still claims that the client comes first for Goldman; most of their clients are surprised to hear that.
B. Small investors also lose out. Who do you think really bears the losses when John Paulson is allowed to (secretly, according to the SEC) design securities that will fail – and then pockets the gains?
3) Underpinning all this power is the ultimate threat: Too Big To Fail. If a big bank is pushed too hard, its failure can bring down the financial system. This usually means protection when the system looks shaky, but it can also protect big banks from serious prosecution – if their defenders, like Jamie Dimon, can make the case that this would undermine system stability and slow the creation fo credit. (This is startlingly parallel to the arguments made by Nicolas Biddle against Andrew Jackson during the 1830s; see chapter 1 of 13 Bankers).
In turn, this puts competitors at a major disadvantage, because the bigger banks can borrow on better terms. The extent of protection provided to management and boards in 2008-09 was excessive, but what really matters is the protection perceived and expected by creditors going forward. And this is all about whether you can credibly threaten the creditors with losses. This, in turn, is about a simple calculus – if a firm is in trouble, will it be saved?
There are simply no social benefits to having banks with over $100 billion in total assets. Think clearly about this – and if you dispute this point, read 13 Bankers; it was written for you.
. . . or, how finance is like quantum mechanics.
This guest post is contributed by StatsGuy, an occasional commenter and contributor to this blog.
Many pundits like to discuss the issue of Maturities Mismatch – that banks borrow short (at low interest), lend long (at higher interest), take the profit and (allegedly) absorb the risk. We often hear talk about how the Maturities Mismatch is integrally linked to liquidity risk – the sometimes self-fulfilling threat of bank runs – which the FDIC is designed to fight. Rarely if ever do we see anyone making the connection to the Discount Rate Mismatch . . . In fact you’ve probably never even heard of it, and neither have I.
What is the Discount Rate Mismatch?
It is the difference between the risk-free return on investment that investors demand, and the risk-free return on investment that can be generated by real world investments. And by investors, I do not just mean individual retail investors or hedge funds. I also mean retirement accounts and state pension funds as well, which rely on massive 8% projected returns in order to avoid officially recognizing massive fiscal gaps between their obligations and funding requirements.
It has been well documented that the existence of these gaps implicitly forces state and municipal retirement agencies to engage in risky investments to hit target asset appreciation goals. This strategy sometimes works. And, sometimes, it does not – as Orange County well remembers.
By Simon Johnson, co-author of 13 Bankers.
On a short-term tactical basis, Goldman Sachs clearly has little to fear. It has relatively deep pockets and will fight the securities “Fab” allegations tooth and nail; resolving that case, through all the appeals stages, will take many years. Friday’s announcement had a significant negative impact on the market perception of Goldman’s franchise value – partly because what they are accused of doing to unsuspecting customers is so disgusting. But, as a Bank of America analyst (Guy Mozkowski) points out this morning, the dollar amount of this specific allegation is small relative to Goldman’s overall business and – frankly – Goldman’s market position is so strong that most customers feel a lack of plausible alternatives.
The main action, obviously, is in the potential widening of the investigation (good articles in the WSJ today, but behind their paywall). This is likely to include more Goldman deals as well as other major banks, most of which are generally presumed to have engaged in at least roughly parallel activities – although the precise degree of nondisclosure for adverse material information presumably varied. Two congressmen have reasonably already drawn the link to the AIG bailout (how much of that was made necessary by fundamentally fraudulent transactions?), Gordon Brown is piling on (a regulatory sheep trying to squeeze into wolf’s clothing for election day on May 6), and the German government would dearly love to blame the governance problems in its own banks (e.g., IKB) on someone else.
But as the White House surveys the battlefield this morning and considers how best to press home the advantage, one major fact dominates. Any pursuit of Goldman and others through our legal system increases uncertainty and could even cause a political run on the bank – through politicians and class action lawsuits piling on.
And, as no doubt Jamie Dimon (the articulate and very well connected head of JP Morgan Chase) already told Treasury Secretary Tim Geithner over the weekend, if we “demonize” our big banks in this fashion, it will undermine our economic recovery and could weaken financial stability around the world.
Dimon’s points are valid, given our financial structure – this is exactly what makes him so very dangerous. Our biggest banks, in effect, have become too big to be held accountable before the law. Continue reading “Goldman Sachs: Too Big To Obey The Law”
By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown
Of all the reactions so far to various dimensions of Goldman fraudulent securities “Fab” scandal, one stands out. On Bill Maher’s show, Friday night, I argued that John Paulson – the investor who helped design the CDO at the heart of the affair – should face serious legal consequences.
On the show, David Remnick of the New Yorker pointed out that Paulson has not been indicted. And since then numerous people have argued that Paulson did nothing wrong – rather that the fault purely lies with Goldman for not disclosing fully to investors who had designed the CDO.
But this is to mistake the nature of the crime here – and also to misread the legal strategy of the SEC. Continue reading “John Paulson Needs A Good Lawyer”
By Simon Johnson
We have waited long and patiently for our Ferdinand Pecora moment – a modern equivalent of the episode when a tough prosecutor from New York seized the imagination of the country in the early 1930s and, over a series of congressional hearings: laid bare the wrong-doings of Wall Street in simple and vivid terms that everyone could understand, and created the groundswell of public support necessary for comprehensive reregulation. On Friday, that moment finally arrived.
There is fraud at the heart of Wall Street, according to the Securities and Exchange Commission. Pecora took on National City Bank and J.P. Morgan (the younger); these were the supposedly untouchable titans of their day. The SEC is taking on Goldman Sachs; no firm is more powerful.
Pecora exposed the ways in which leading banks mistreated their customers – typically, retail investors. The SEC alleges, with credible detail, that Goldman essentially set up some trusting clients and deliberately misled them – to the tune of effectively transferring $1 billion from them to a particular unscrupulous investor. Continue reading “Our Pecora Moment”
By James Kwak
Press release here. Complaint here. The allegation is that Goldman failed to disclose the role that John Paulson’s hedge fund played in selecting residential mortgage-backed securities that went into a CDO created by Goldman. Here’s paragraph 3 of the complaint:
“In sum, GS&Co arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.”
The problem is that the marketing documents claimed that the securities were selected by ACA Management, a third-party CDO manager, when in fact the selection decisions were influenced by Paulson’s fund. Goldman had a duty to disclose that influence, especially since Paulson was simultaneously shorting the CDO. (According to paragraph 2 of the complain, he bought the credit default swaps from Goldman itself. I used to wonder about this; if he bought the CDS from another bank, then Goldman could claim it didn’t know he was shorting the CDO, implausible as that claim might be. But in this case Goldman must have known.)
The Baseline Scenario 
