So Damn Little Money

By Simon Johnson

The financial reform legislation currently heading into a June Senate-House conference will, at best, do little to affect the incentives and beliefs at the heart of the largest banks on Wall Street. Serious attempts to strengthen the bill through amendment – such as Brown-Kaufman and Merkley-Levin – were either shot down on the floor of the Senate or, when their prospects seemed stronger, not allowed to come to a vote.

Senator Blanche Lincoln is holding the Alamo with regard to reining in the big broker-dealers in derivatives. But these same people are bringing to bear one of the most intensely focused lobbying campaigns of recent years, bent on killing her provisions (or weakening them beyond recognition). All the early indications are that the lobbyists, once again, will prevail.

At one level, Robert Kaiser nailed this topic in his recent book, “So Damn Much Money: The Triumph of Lobbying and the Corrosion of American Government.” Elections have become more expensive, with most of the funding provided by special interests. You can argue about which is the chicken and which is the egg, but the basic facts are inescapable. Continue reading “So Damn Little Money” →

Wall Street CEOs Are Nuts

By James Kwak

“Geithner’s team spent much of its time during the debate over the Senate bill helping Senate Banking Committee chair Chris Dodd kill off or modify amendments being offered by more-progressive Democrats. A good example was Bernie Sanders’s measure to audit the Fed, which the administration played a key role in getting the senator from Vermont to tone down. Another was the Brown-Kaufman Amendment, which became a cause célèbre among lefty reformers such as former IMF economist Simon Johnson. ‘If enacted, Brown-Kaufman would have broken up the six biggest banks in America,’ says the senior Treasury official. ‘If we’d been for it, it probably would have happened. But we weren’t, so it didn’t.'”

Oh, well.

That’s one passage from John Heileman’s juicy article in New York Magazine. It provides a lot of background support for what many of us have been thinking for a while: the administration is happy with the financial reform bill roughly as it turned out, and it got there by taking up an anti-Wall Street tone (e.g., the Volcker Rule), riding a wave of populist anger to the point where the bill was sure of passing, and then quietly pruning back its most far-reaching components. If anything, that’s a testament to the political skill of the White House and, yes, Tim Geithner as well.

Continue reading “Wall Street CEOs Are Nuts” →

The Last Hold Out: Senator Blanche Lincoln Against 13 Bankers

By Simon Johnson

By now you have probably realized – correctly – that “financial reform” has turned into a victory lap for Wall Street.

When they saved the big banks, with massive unconditional support (both explicit and implicit) over a year ago, top administration officials promised they would be back later to fix the underlying problems. This they – and Congress – manifestly have failed to do.

Our banking structure remains unchanged, the rules will be tweaked at the margins, and the incentive and belief system that lies behind reckless risk-taking has only become more dangerous. (The back story, if you can still stomach it, is in 13 Bankers).

There is only one small chance for any sensible progress remaining – and you are about to see this crushed in conference by the supporters of unfettered big banks. Continue reading “The Last Hold Out: Senator Blanche Lincoln Against 13 Bankers” →

Regulation vs. Structural Change

By James Kwak

Robert Reich discusses a theme that I think I’ve discussed before (and first heard expressed by Ezra Klein):

“The most important thing to know about the 1,500 page financial reform bill passed by the Senate last week — now on he way to being reconciled with the House bill — is that it’s regulatory. It does nothing to change the structure of Wall Street.”

Continue reading “Regulation vs. Structural Change” →

Why Does Steve Ballmer Still Have a Job?

By James Kwak

So, after questioning the iPad, I bought one.* My primary motivation was that I wanted to be able to watch old TV episodes on the commute to and from my internship this summer, and I think an iPod Touch is just too small. I also bought an Android phone, because my three-year-old Motorola RAZR2 v9m (who comes up with these product names, anyway?) developed a crack in the hinge, and because I wanted the best camera I could get on a phone. (My #2 use for a phone is not email — it’s taking pictures and videos of my daughter.)

Anyway, catching up on the last three years of mobile technology has provided ample food for thought. I have a long post on the Apple-Google(-Microsoft) war rolling around in my head somewhere, which I will hopefully write down later this week. In the meantime, here’s John Gruber‘s verdict on Microsoft:

“Three years ago, just before the original iPhone shipped, here’s what Steve Ballmer said in an interview with USA Today’s David Lieberman:

‘There’s no chance that the iPhone is going to get any significant market share. No chance. It’s a $500 subsidized item. They may make a lot of money. But if you actually take a look at the 1.3 billion phones that get sold, I’d prefer to have our software in 60 percent or 70 percent or 80 percent of them, than I would to have 2 percent or 3 percent, which is what Apple might get.’

“Not only was he wrong about the iPhone, but he was even more wrong about Windows Mobile. Three years ago Ballmer was talking about 60, 70, 80 percent market share. This week, Gartner reported that Windows Mobile has dropped to 6.8 percent market share in worldwide smartphone sales, down dramatically from 10.2 percent a year ago.”

Continue reading “Why Does Steve Ballmer Still Have a Job?” →

The Road To Economic Serfdom

By Peter Boone and Simon Johnson

According to Friedrich von Hayek, the development of welfare socialism after World War II undermined freedom and would lead western democracies inexorably to some form of state-run serfdom.

Hayek had the sign and the destination right but was entirely wrong about the mechanism. Unregulated finance, the ideology of unfettered free markets, and state capture by corporate interests are what ended up undermining democracy both in North America and in Europe. All industrialized countries are at risk, but it’s the eurozone – with its vulnerable structures – that points most clearly to our potentially unpleasant collective futures.

As a result of the continuing euro crisis, European Central Bank (ECB) now finds itself buying up the debt of all the weaker eurozone governments, making it the – perhaps unwittingly – feudal boss of Europe. In the coming years, it will be the ECB and the European Union who dictate policy. The policy elite who run these structures – along with their allies in the private sector – are the new overlords. Continue reading “The Road To Economic Serfdom” →

The Mystery of Capital

By James Kwak

So the dust has settled on the Senate bill, and it remains studiously vague about capital requirements — no hard leverage cap, for example. This is what the administration wanted, for two reasons: first, they claim that regulators need ongoing flexibility to modify capital requirements; second, they claim that they need flexibility to negotiate a uniform international agreement.

There is one thing in there that is controversial enough to get the attention of the bank lobbyists: the Collins Amendment, which Mike Konczal has written about here. The main provision of the amendment is that whatever capital requirements apply to insured depositary institutions (banks), they also have to apply to systemically important financial institutions, including at the holding company level.

Sheila Bair of the FDIC is in favor of the amendment, on the argument that bank holding companies should not be able to evade capital requirements that are imposed on their subsidiary insured banks; she doesn’t want to regulate the depositary institutions but have all her work rendered irrelevant because the holding company collapses, triggering a mess of cross-guarantees.

This seems entirely unobjectionable, but as Konczal points out, the real threat to the banks is that it makes it harder for them to engage in financial engineering on the holding company level to evade capital requirements. According to the Wall Street Journal, not only the banks, but also the administration itself is planning to try to kill this amendment (at this point, in conference committee).

Continue reading “The Mystery of Capital” →

The VC Tax Break

By James Kwak

The House of Representatives is considering a bill that would change the tax treatment of venture capitalists’ income (and that of private equity fund managers as well). Currently, VCs typically are paid “2 and 20” — that is, an annual fee of 2 percent of assets, plus 20 percent of profits. For example, let’s say a fund starts out with $200 million. Most of that money is invested by the fund’s limited partners — pension funds, endowments, insurance companies, the usual suspects. After ten years (roughly the average life of a VC fund), the investments made by the fund are now worth $400 million — a pretty humdrum return of 7 percent per year (before fees). The venture capitalists themselves will earn about $14 million ($200 million x 2% x 7 years)* plus $40 million (20% x ($400 million – $200 million)) equals $54 million. (Note that they earn that $40 million even for doing worse than the stock market’s long-term average return.) The limited partners get what’s left over after those fees. And before you start crying for the VCs, remember that a typical VC firm will have multiple VC funds going at once.

Right now, the $14 million is taxed as ordinary income, but the $40 million is taxed as capital gains — that is, at a tax rate of 15%. The bill would tax the $40 million as ordinary income (actually, 75% as ordinary income and 25% as capital gains), for an effective tax rate of about 35%.

The current tax treatment has never made sense to me. The lower rate on capital gains is supposed to provide an incentive for capital investment.** This is why, if you buy stock and sell it more than a year later, you pay tax on your gains at a lower rate. So clearly the actual investment returns on money invested in the VC fund should be treated as capital gains — but not the VCs’ 20 percent fee, since that’s compensation for fund management services, not returns on their investment. (VCs typically invest their own money in a fund, but it is only a small fraction of the whole, and no one is debating how that money should be treated.)

Continue reading “The VC Tax Break” →

Focus On This: Merkley-Levin Did Not Get A Vote

By Simon Johnson

After 9 months of hard fighting, yesterday financial reform came down to this: an amendment, proposed by Senators Jeff Merkley and Carl Levin that would have forced big banks to get rid of their speculative proprietary trading activities (i.e., a relatively strong version of the Volcker Rule.)

The amendment had picked up a great deal of support in recent weeks, partly because of unflagging support from Paul Volcker and partly because of the broader debate around the Brown-Kaufman amendment (which would have forced the biggest 6 banks to become smaller). Brown-Kaufman failed, 33-61, but it demonstrated that a growing number of senators were willing to confront the power of our biggest and worst banks.

Yet, at the end of the day, the Merkley-Levin amendment did not even get a vote. Why? Continue reading “Focus On This: Merkley-Levin Did Not Get A Vote” →

Reforming Credit Rating Agencies

This guest post was contributed by Gary Witt, an assistant professor in statistics and finance at the Fox Business School at Temple University. He was previously an analyst and then a managing director at Moody’s Investors Service rating CDOs from September 2000 until September 2005. Witt also caught one error in 13 Bankers, which I explain here.

Many readers will think that the last person whose opinion should be consulted on the issue of rating agency reform is a former rating agency employee. Maybe they’re right, but I did learn one thing from rating hundreds of complex securities. Contrary to what some may think, there are no easy solutions here. Unintended consequences are guaranteed. So here’s my humble take on the current CRA reform proposals.

What should be the goal of rating agency reform?

In 2007, as S&P and Moody’s were trying to decide how to rerate the entire structured finance debt market, I asked a shrewd fund manager what advice he would give to the management of a rating agency. He said they have to get the ratings right. No matter how hard it is, they have to focus on getting the ratings right.

There is an alternative school of thought. Instead of improving ratings, the reform agenda should be to be to eliminate their use. Since the rating agencies are hopelessly stupid or corrupt or both, just say no. End the market’s addiction to credit ratings by eliminating the SEC designation Nationally Recognized Statistical Rating Organization (NRSRO). Go cold turkey and end the practice of using ratings to assess credit risk by governmental or regulatory entities.

These two competing goals, improve credit ratings and eliminate credit ratings, can be viewed from a larger perspective, a Minsky mindset. If stability breeds instability, then trust breeds disappointment; the greater the trust, the bigger the disappointment. The rating agencies were over-trusted until 2007.

Continue reading “Reforming Credit Rating Agencies” →

The Very Bad Luck of The Irish

By Peter Boone and Simon Johnson

With the European Central Bank announcing that it has bought more than $20 billion of mostly high-risk euro zone government debt in one week, its new strategy is crystal clear: We will take the risk from bank balance sheets and give it to the central bank, and we expect Portugal-Ireland-Italy-Greece-Spain to cut fiscal spending sharply and pull themselves out of this mess through austerity.

But the bank’s head, Jean-Claude Trichet, faces a potential major issue: the task assigned to the profligate nations could be impossible. Some of these nations may be stuck in a downward debt spiral that makes greater economic decline ever more likely. Continue reading “The Very Bad Luck of The Irish” →

The Middle Ground On Financial Reform

By Simon Johnson

In Politico this morning, I question whether the president should really be seen as “centrist” or “moderate” with regard to financial reform. His staff goes to great lengths to make this claim, including both the specific quotes and general tone in the Financial Times on Tuesday (May 18, p.7).

Treasury Secretary Tim Geithner:

“I would say [the president] is fundamentally at the centre and pro-market. But he recognizes the market cannot solve all problems.”

Larry Summers:

“Sometimes the most courageous thing to do is not to take the largest and most sweeping course of action.”

But if this is the correct way to frame the president’s position, how can we explain the fact that it is moderates – not left-wing radicals – who are pushing (against the White House, among others) for stronger reform both within the administration and in Congress? I suggest another interpretation: On financial reform, the president does not hold the middle ground.

Fire Up Twitter

The White House has over 1.75 million followers on Twitter.

The latest presidential tweet is a bit stale (17 hours ago), but right on target.

“Obama to Senate GOP blocking increase in oil company liability: “stop playing special interest politics” http://bit.ly/d65jfY“

The White House needs to send out the exact same message, but replacing “increase in oil company liability” with “financial reform”, and then linking to the Merkley-Levin amendment and the imminent failure of the Volcker Rule and meaningful financial reform.

How hard can that be?

Update (12:40pm): at about 10:30am, the president’s staff put out this tweet (@BarackObama; i.e., http://twitter.com/BarackObama, with nearly 4 million followers):

“It’s time for Wall St. reform that gives greater security to folks on Main Street. Call your Republican Senators today: http://j.mp/cwhtg7“

Good tweet – but the president should call explicitly for Merkley-Levin to pass; this is his own Volcker Rule, after all. Here’s Senator Jeff Merkley, to the point: http://twitter.com/senjeffmerkley

In Defense Of Europe’s Grand Bargain

This guest post is by Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics. He is more positive than the current consensus on recent economic and political developments in the eurozone.

The frantic spectacle of European leaders struggling to avert a financial crisis caused by Greece has seemed unsettling and at times amateurish. It is certainly easy to point fingers at policy makers patching solutions together solutions that immediately unravel under pressure from the markets, and to do so again and again over the last several weeks.

But if you look less at the sausage-making process and more at the final result, you have to be impressed. There are of course many painful steps that still need to be undertaken by all sides – the Greeks, the weaker European economies, the European banks and the European governments. But the derision of some commentators and the uneasiness of the markets seems overstated.

Recall the disdain, for example, when the TARP was introduced in late 2008 or the bank stress-tests were carried out last year. Today most would argue that they ultimately played a large and constructive role in containing the immediate crisis contagion. In time, Europe’s response to the Greek crisis will be viewed in a similar positive light. Continue reading “In Defense Of Europe’s Grand Bargain” →

Finally, The Republicans Come Out To Fight. Where Is The President?

The Senate Republicans are refusing to allow a vote on the Merkley-Levin amendment, which would put a meaningful version of the Volcker Rule into law (splitting off proprietary trading from major banks).

After weeks of dancing around, the Democrats finally have a signature issue on which to fight. Senator Carl Levin frames it exactly right: “It’s a sad day when the power of Wall Street can overwhelm the power of the American people in the US Senate.”

This is the opportunity that White House claims it has long sought – to have an intense fight on a financial reform issue that everyone can understand. Paul Volcker made his determination long ago: the big banks are too big and must, in this fashion, be broken up. Senators Merkley and Levin negotiated the precise language of their amendment in good faith. The Republicans have made their answer clear: No way.

Time for President Obama to make the call. Continue reading “Finally, The Republicans Come Out To Fight. Where Is The President?” →