San Diego Housing Bubble News and Analysis

By L. Randall Wray, a Professor of Economics at the University of Missouri-Kansas City who writes at New Economic Perspectives

Just when you thought that nothing could stink more than Timothy Geithner’s handling of the AIG bailout, a new report details how Geithner’s New York Fed allowed Lehman Brothers to use an accounting gimmick to hide debt. The report, which runs to 2200 pages, was released by Anton Valukas, the court-appointed examiner. It actually makes the AIG bailout look tame by comparison. It is now crystal clear why Geithner’s Treasury as well as Bernanke’s Fed refuse to allow any light to shine on the massive cover-up underway.

Recall that the New York Fed arranged for AIG to pay one hundred cents on the dollar on bad debts to its counterparties—benefiting Goldman Sachs and a handful of other favored Wall Street firms. The purported reason is that Geithner so feared any negative repercussions resulting from debt write-downs that he wanted Uncle Sam to make sure that Wall Street banks could not lose on bad bets. Now we find that Geithner’s NYFed supported Lehman’s efforts to conceal the extent of its problems. Not only did the NYFed fail to blow the whistle on flagrant accounting tricks, it also helped to hide Lehman’s illiquid assets on the Fed’s balance sheet to make its position look better. Note that the NY Fed had increased its supervision to the point that it was going over Lehman’s books daily; further, it continued to take trash off the books of Lehman right up to the bitter end, helping to perpetuate the fraud that was designed to maintain the pretense that Lehman was not massively insolvent.

Geithner told Congress that he has never been a regulator. That is a quite honest assessment of his job performance, although it is completely inaccurate as a description of his duties as President of the NYFed. Apparently, Geithner has never met an accounting gimmick that he does not like, if it appears to improve the reported finances of a Wall Street firm. We will leave to the side his own checkered past as a taxpayer, although one might question the wisdom of appointing someone who is apparently insufficiently skilled to file accurate tax returns to a position as our nation’s chief tax collector. What is far more troubling is that he now heads the Treasury—which means that he is not only responsible for managing two regulatory units (the FDIC and OCC), but also that he has got hold of the government’s purse strings. How many more billions or trillions will he commit to a futile effort to help Wall Street avoid its losses?

Geithner has denied that he played any direct role in the AIG bail-out—a somewhat implausible claim given that he was the President of the NYFed and given that this was a monumental and unprecedented action to funnel government funds to AIG’s counterparties. He may try to deny involvement in the Lehman deals. (Again, this is implausible. Lehman executives claimed they “gave full and complete financial information to government agencies”, and that the government never raised significant objections or directed that Lehman take any corrective action. In fairness, the SEC also overlooked any problems at Lehman. But here is what is so astounding about the gimmicks: Lehman used “Repo 105” to temporarily move liabilities off its balance sheet—essentially pretending to sell them although it promised to immediately buy them back. The abuse was so flagrant that no US law firm would sign off on the practice, fearing that creditors and stockholders would have grounds for lawsuits on the basis that this caused a “material misrepresentation” of Lehman’s financial statements. The court-appointed examiner hired to look into the failure of Lehman found “materially misleading” accounting and “actionable balance sheet manipulation.” (here) But just as Arthur Andersen had signed off on Enron’s scams, Ernst & Young found no problem with Lehman.

In short, this was an Enron-style, go directly to jail and do not pass go, sort of fraud. Lehman’s had been using this trick since 2001. It looked fine to Timmy’s Fed, which extended loans allowing Lehman to flip bad assets onto the Fed’s balance sheet to keep the fraud going.

More generally, this revelation drives home three related points. First, the scandal is on-going and it is huge. President Obama must hold Geithner accountable. He must determine what did Geithner know, and when did he know it. All internal documents and emails related to the AIG bailout and the attempt to keep Lehman afloat need to be released. Further, Obama must ask what has Geithner done to favor his clients on Wall Street? It now looks like even the Fed BOG, not just the NYFed, is involved in the cover-up. It is in the interest of the Obama administration to come clean. It is hard to believe that it does not already have sufficient cause to fire Geithner. In terms of dollar costs to the government, this is surely the biggest scandal in US history. It terms of sheer sleaze does it rank with Watergate? I suppose that depends on whether you believe that political hit lists and spying that had no real impact on the outcome of an election is as bad as a wholesale handing-over of government and the economy to Wall Street.

What did Timmy know, and when did he know it?

Point number two. Lehman used an innovation, “Repo 105” to hide debt. The whole Greek debt fiasco was caused by Goldman, et. al., who helped hide government debt. Whether legal or illegal, Wall Street has for many years been producing financial instruments designed to mislead shareholders, creditors, and regulators about the true financial position of its clients. Note that Lehman’s counterparties in this fraud included JP Morgan and Citigroup (who actually precipitated Lehman’s final failure when they finally called in their loans). It always takes at least three to tango: the firm that wants to hide debt, the counterparty that temporarily takes it off their books, and the accounting firm that provides the kiss of approval.

Worse, after aiding and abetting such deception, Goldman and other Wall Street institutions then place bets (using another nefarious innovation, credit default swaps) against their clients, wagering that they will not be able to service the debts—which are greater than the market believes them to be. Does that sound something like insider trading? How can regulators permit such actions?

What did Timmy know, and when did he know it?

Third point. To the extent that debt is hidden, financial institution balance sheets present an overly rosy picture—of course, that is the purpose of the financial “innovations”. Enron did it; AIG did it; Lehman did it. What about Bank of America, Citi, JP Morgan, Wells Fargo and Goldman? We now know that the New York Fed subjected Lehman to three wimpy “stress tests”, all of which it failed. Timmy’s Fed then allowed Lehman to construct its own sure-to-pass “stress” test. (We know, of course, that the test was absolutely meaningless because, well, Lehman passed the test and then immediately failed spectacularly. Timmy then let the biggest banks run their own stress tests, which they (surprise, surprise) managed to pass.

What did Timmy know, and when did he know it?

As our all-time favorite Fed Chairman Alan Greenspan liked to put it, “history shows” that when financial institutions pass their own stress tests, they are actually massively insolvent. There is no reason to believe that this time will be different. Mike Konczal reports that there is every reason to believe the biggest banks are hiding huge losses on second liens. These are second mortgages or home equity loans that amount to about $1 trillion of which almost half are held by the top four banks. Since the first principal of a mortgage is paid first, it is likely that much of the second liens are worthless. Yet banks are carrying these on their books at 86 to 87 percent of face value—which was necessary to allow them to pass the stress tests. Konczal shows that at a more reasonable loss rate of 40% to 60%, the four largest banks would have “an extra $150 billion hole in the balance sheet”. I won’t go into the policy conundrum implied for President Obama’s plan for principal reduction to help homeowners (the banks will not allow renegotiation of underwater mortgages because that would force them to recognize losses on the second liens).

Of greater importance is the recognition that all of the big banks are probably insolvent. Another financial crisis is nearly certain to hit in coming months—probably before summer. The belief that together Geithner and Bernanke have resolved the crisis and that they have put the economy on a path to recovery will be exposed as wishful thinking. In the bigger scheme of things, this is only 1931. We have a long way to go before bank assets (and nonbank debts) are written down sufficiently to allow a real recovery. In other words, a Minsky-Fisher debt deflation is still in the cards.

By Washington.

Upton Sinclair said:

It is difficult to get a man to understand something, when his salary depends upon his not understanding it.

Bestselling financial writer Michael Lewis is now saying the same thing. In an interview with 60 Minutes, Lewis said:

Wall Street is able to delude itself because it’s paid to delude itself. That’s one of the lessons of this story. People see what they’re incentivized to see. If you pay someone not to see the truth, they won’t see the truth.

As Lewis makes clear, the broken incentive system causes the heads of the Wall Street giants to act in ways which are not only destructive to the economy as a whole and to American jobs, but to the long-term health of their own companies.

If the broken incentive system were fixed, Wall Street big shots could suddenly be able to “see” the destructive effects of fraudulent and risky behavior. That would take politicians getting out of bed with Wall Street for a couple of minutes, which is unlikely, given how warm and cozy it is Unfortunately, that’s probably not politically feasible.

Of course, executive compensation should be linked to performance, in the sense of creating sustainable wealth for shareholders and the economy as a whole. But if the companies and politicians are too spineless to do that, at least ill-gotten gains could be taken away after the fact when executives are found to have committed fraud or driven their companies into the ground.

For example, as I wrote last April:

[William K. Black - the senior regulator during the S&L crisis, and an Associate Professor of Economics and Law at the University of Missouri ] provided the historical background to the PCA [The Prompt Corrective Action Law (PCA)] in a little-noticed essay last month:

… PCA also recognized that failing bankers had perverse incentives to “live large” and cause larger losses to the FDIC and taxpayers. PCA’s answer was to mandate that the regulators stop these abuses by, for example, strictly limiting executive compensation and forbidding payments on subordinated debt.

As I wrote last June:

Because the current incentive for high-level corporate people is to commit fraud. Even if they are caught and go to jail, they’ll be rich when they get out.

Hitting the crooks in the wallet is the only thing which will motivate people not to rip off their shareholders, the taxpayers and the American treasury.

As Paul Volcker says, the incentive systems at financial firms are broken.

Hitting wrongdoers with big fines will help fix them.

***

And Nobel prize-winning economist George Akerlof co-wrote a paper in 1993 describing the reasons for financial meltdowns:

Financial crises in the 1980s, like the Texas real estate bust, had been the result of private investors taking advantage of the government. The investors had borrowed huge amounts of money, made big profits when times were good and then left the government holding the bag for their eventual (and predictable) losses.

In a word, the investors looted. Someone trying to make an honest profit, Professors Akerlof and Romer [co-author and himself a leading expert on economic growth] said, would have operated in a completely different manner. The investors displayed a “total disregard for even the most basic principles of lending,” failing to verify standard information about their borrowers or, in some cases, even to ask for that information.

The investors “acted as if future losses were somebody else’s problem,” the economists wrote. “They were right.”

If enough people … are hit with [large] fines for fraud, future losses will not be somebody else’s problems, but their own.

That would make the game of financial fraud a lot less profitable, and so undermine much of the motivation of corporate big-wigs to commit fraud. And – given that Black says that massive fraud is what caused the economic crisis – that in turn would save the taxpayers from having to fund many billions in bailouts . . .

Of course, the antisocial tendencies of those running the financial giants doesn’t help.

The incentives should – of course – be on the front end, so that Wall Street folks are dissuaded from committing fraud in the first place.

At the very least, they should be at the back end, so that any profits made by fraud are recouped and put back in the government coffers.

Alternatively, James Kwak suggests a novel approach:

As Kwak writes:

Why not say that all bank compensation above a baseline amount – say, $150,000 in annual salary – has to be paid in toxic assets off the bank’s balance sheet? Instead of getting a check for $10,000, the employee would get $10,000 in toxic assets, at their current book value. . . . That would get the assets off the bank’s balance sheet, and into the hands of the people responsible for putting them there – at the value that they insist they are worth . . . think about the incentives: talented people will flow to the companies that are valuing their assets the most realistically (since inflated valuations translate directly into lower compensation), which will give companies the incentive to be realistic in their valuations.

Of course, there’s an argument that the executives’ base salary should be paid in toxic assets as well. Since these fatcats don’t seem to be motivated to run their companies well so as to save the economy and the people, maybe having their own salaries on the line will motivate them. But if you believe that is too harsh, at least demand that their bonuses be paid in this way.

… Apparently, Credit Suisse is already doing this.

A reader wrote to tell me his firm had been shown transactions at the end of 2007 from an investment bank (not Lehman) that he was confident were to tart up its balance sheet. This confirms the hardly shocking idea that window dressing was not limited to Lehman:

Around Dec 2007 bank I work for was approached by XXX to transact a total return swap transaction. The underlying for the TRS would be a large portfolio of ABSes (and CDO tranches – name your toxic stuff, it was there). The deal was offered as “You do TRS with us, we sell you the portfolio and at the end of the deal we buy the portfolio back, no risk, hey?”. It was very clear to me that this was a balance-sheet dressing exercise, as they were very keen to do the transaction before their reporting date.

When I pointed it to our legal dept., they said that since they are doing legal thing, it’s all OK. In the end we turned the transaction down anyway (and, in line with my suspicions about the reason once the reporting date passed they enthusiasm for the transaction evaporated).

Our salesperson could not understand that this was a credit product on XXX, and that just because transaction like this might have priced at 10bp over Libor two years ago, with XXX CDS spreads in their hundreds pricing it at 30bp was NOT a good price.

In general, some credit intermediation trades that some of the large players tried to suck other banks into were unbelievable.

It was also really interesting from the incentives perspective – sometimes it was clear that the transaction people were trying to shove around in the market was a potential time-bomb, but sales people still wanted to do it as the processes they had to follow, and criteria for their performance were by then obsolete and easily gameable.

For example some of the counterparties were still ranked as good/excellent credit risk in the systems, even though they were on the verge of going under, so computed return on equity on the transaction was all of sudden huge, and the computed risk small. Of course, the reality was quite opposite, but when was the last time a reality check stopped a determined sales person? And if the counterparty got downgraded afterwards, they could still say “yeah, but when I did the deal, it was OK… And if I could predict the future, I’d be a trader, not a salesperson.”

To Arctic Animals, Time of Day Really Doesn’t Matter Science Daily (hat tip reader John M)

Psychopaths’ brains wired to seek rewards, no matter the consequences PhysOrg. So that means the only answer is to put them in jail?

Goldman Sachs derivative liability = 33,823% of assets The Bankwatch (hat tip reader Steve L). Yo!

Taking On China Paul Krugman, New York Times

He’ll Go Free Charles Gasparino, The Daily Beast. (hat tip reader Crocodile Chuck) Gasparino was dead wrong on Lehman v. his critics. Let’s hope his take on Fuld is another counterindicator.

Further Lehmans revelations blocked by Barclays Times Online

Rating agency warns on US public finances Financial Times. Notice how analysts quoted in the piece shrugged it off.

Record numbers contact debt charity Telegraph

Planet Money Podcast, Auto Lenders, and an Amazing GOP Machine Mike Konczal

Lagarde criticises Berlin policy Financial Times

Antidote du jour. I honestly do not know how this story ended, but with so many people there, I assume the horse got rescued eventually:

By Rob Parenteau, CFA, sole proprietor of MacroStrategy Edge, editor of The Richebacher Letter, and a research associate of The Levy Economics Institute

This 2009 analysis by UBS, presented in FT Alphaville, debunks a central tenet of the deficit terrorist camp:

If the deficit terrorists were correct, there should be a much more defined population of the northeast quadrant of the graph attached and discussed in the link. Increases in public debt/GDP ratios should, under the logic of deficit terrorists like Pete Peterson, be associated with observations of escalating inflation. There should be a well defined cloud of historical observations moving up and to the right from the origin of this graph. No such thing to be observed.

Of course, one must be careful with this UBS analysis, since neither do they find a cloud of observations moving definitively in the southwest corner, as many of us might expect from fiscal retrenchment sucking cash flow out of, and reducing the net worth and net financial assets held by the private sector. Public debt to GDP ratios can obviously fall because the denominator is growing more quickly than the numerator, so again, this is a crude display at best, but I know from experience these do tend to become touchstones of market lore.

It also commits the heresy of assuming bond investors can en masse “require” an inflation premium without reducing the value of their existing holdings, a paradox Keynes used to critique Fisher’s interest rate theory which Jan Kregel has highlighted in some of his work, but still remains largely ignored by many.

Relations between the US and China have been deteriorating. Although both sides have poked each other in various ways (Obama meeting with the Dalai Lama, China dissing Obama in Copenhagen by standing him up for a meeting, some tit for tat on tariffs), the major, unresolved bone of contention is China’s pegging of its currency, the renminbi, at a level most experts deem to be undervalued. This has widespread ramifications: a continuation of global imbalances (one of the causes of the financial crisis) and preserving Chinese employment at the expense of its trading partners.

The US has strengthened its push for China to Do Something about the renminbi, meaning revalue it, with Obama calling for a “more market-oriented exchange rate”. Some analysts have forecast a rise of 5% this year. But the noise out of Beijing suggests otherwise. From Bloomberg:

Chinese Premier Wen Jiabao rebuffed calls for the yuan to appreciate, risking a further downturn in relations with the U.S. where lawmakers and economists say his stance is hampering a global recovery.

“I don’t think the renminbi is undervalued,” Wen said yesterday at a press conference in Beijing marking the end of China’s annual parliamentary meetings, using another term for the yuan. “We oppose countries pointing fingers at each other and even forcing a country to appreciate its currency.”

Yves here. The reason this issue is coming to the forefront now is twofold. One is that the Obama administration’s falling poll ratings are forcing it to address a central issue that it has neglected, namely, unemployment. The measures so far, a stimulus packages that most economists deem to be inadequate, and extending unemployment benefits, have simply blunted the severity of the problem rather than solved it. A cheaper dollar would bring jobs back to the US (in fact, manufacturers like Caterpillar have already started repatriating jobs. And before readers start arguing in favor of cheap Chinese labor, most firms who have outsourced and offshored have found cost savings to come up well short of expectations. Why? First, labor costs are a relatively small component of most manufactured goods. Even in a supposedly-hopeless-for-advanced-economies field like apparel, some US manufacturers like American Apparrel are paying $12-$13 an hour for workers who make T-shirts and sweatshirts, supposedly commodity items, and still show a profit). Sending work overseas greatly increases administrative costs, which involves much higher paid workers, along with higher shipping and inventory financing costs).

Two is that the Treasury faces an April 15 deadline to decide whether to label China a currency manipulator. That in turn would allow the US to impose retaliatory tariffs. Even normally pro-trade economists like Paul Krugman have pointed out that countries that persistently undervalue their currencies are effectively stealing jobs from their trade partners. While allowing currencies to adjust is the best remedy, taking steps like imposing tariffs to counter the Chinese export subsidy of an artificially cheap RMB is a fallback.

Our initial take was that Team Obama would stage a repeat of its stance last year: saber rattle and do nothing. But there is now bi-partisan pressure on the Obama administration to act. Not only is this move likely to be a winner domestically (and Obama is in desperate need of a win), China’s position is untenable. It has no ready way to retaliate against the US without damaging itself. Stop buying Treasuries at auction? That would drive the RMB up, exactly what they are trying to avoid. Apply tariffs to US goods? Yes, that would hurt specific US exporters, but given China’s massive trade surplus with the US, we come out net ahead on any trade war. Withhold strategic US imports, like chips? That could be disruptive short term, but would lead over time to permanent relocation of production outside China.

Ambrose Evans-Pritchard in the Telegraph contends that China is badly overestimating its power, and will come out the loser if it does not back down:

China has succumbed to hubris. It has mistaken the soft diplomacy of Barack Obama for weakness, mistaken the US credit crisis for decline, and mistaken its own mercantilist bubble for ascendancy. There are echoes of Anglo-German spats before the First World War, when Wilhelmine Berlin so badly misjudged the strategic balance of power and over-played its hand….

Clearly, Beijing is in denial about is own part in the global imbalances behind the credit crisis, specifically by running structural trade surpluses, and driving down long rates through dollar and euro bond purchases. No doubt the West has made a hash of things, but the Chinese view of events is twisted to the point of delusional.

What interests me is Beijing’s willingness to up the ante. It has vowed sanctions against any US firm that takes part in a $6.4bn weapons contract for Taiwan, a threat to ban Boeing from China and a new level of escalation in the Taiwan dispute…

We have talked ourselves into believing that China is already a hyper-power. It may become one: it is not one yet. China is ringed by states – Japan, Korea, Vietnam, India – that are American allies when push comes to shove. It faces a prickly Russia on its 4,000km border, where Chinese migrants are itching for Lebensraum across the Amur. Emerging Asia, Brazil, Egypt and Europe are all irked by China’s yuan-rigged export dumping.

Michael Pettis from Beijing University argues that China’s reserves of $2.4 trillion – arguably $3 trillion – are a sign of weakness, not strength. Only twice before in modern history has a country amassed such a stash equal to 5pc-6pc of global GDP: the US in the 1920s, and Japan in the 1980s. Each time preceeded depression.

The reserves cannot be used internally to support China’s economy. They are dead weight, beyond any level needed for macro-credibility. Indeed, they are the ultimate indictment of China’s dysfunctional strategy, which is to buy $30bn to $40bn of foreign bonds every month to hold down the yuan, refusing to let the economy adjust to trade realities. The result is over-investment in plant, flooding the world with goods at wafer-thin export margins. China’s over-capacity in steel is now greater than Europe’s output.

This is catching up with China, in any case. Professor Victor Shuh from Northerwestern University warns that the 8,000 financing vehicles used by China’s local governments to stretch credit limits have built up debts and commitments of $3.5 trillion, mostly linked to infrastructure. He says the banks may require a bail-out nearing half a trillion dollars.

As America’s creditor – owner of some $1.4bn of US Treasuries, agency bonds, and US instruments – China can exert leverage. But this is not what it seems. If the Politburo deploys its illusiory power, Washington can pull the plug on China’s export economy instantly by shutting markets. Who holds whom to ransom?

Any attempt to retaliate by triggering a US bond crisis would rebound against China, and could be stopped – in extremis – by capital controls. Roosevelt changed the rules in 1933. Such things happen. The China-US relationship is no doubt symbiotic, but a clash would not be “mutual assured destruction”, as often claimed. Washington would win.

Contrary to myth, the slide to protectionism after the 1930 Smoot-Hawley Tariff Act did not cause the Depression. Trade contracted more slowly in the 1930s than this time. The Smoot-Hawley lesson is that tariffs have asymmetrical effects. They devastate surplus countries: then America. Deficit Britain did well by retreating into Imperial Preference.

Barack Obama has never exalted free trade. This orthodoxy is, in any case, under threat in the West. His top economic adviser Larry Summers let drop in Davos that free-trade arguments no longer hold when dealing with “mercantilist” powers. Adam Smith recognized this too, despite efforts by free-trade ultras to appropriate him for their cause.

China’s transformation has been remarkable since Deng Xiaoping unleashed capitalism, but as ex-diplomat George Walden writes in China: a Wolf in the World? you cannot feel at ease with a regime that still covers up Mao’s murderous nihilism. He reminds us too that China has never forgiven the humiliations inflicted by the West when the two civilizations collided in the 19th Century, and intends to exact revenge. Handle with care.

Update 12:45 AM: Team Obama seems to be laying the ground domestically for a serious spat, given the latest PR sighting via the New York Times, “China Uses Rules on Global Trade to Its Advantage.” Looks like the American populace is being “educated” that China plays dirty. Not that I disagree, mind you, but the timing and the placement of the story (front page) is revealing.

By Washington.  Note: I can’t get the videos to embed. Please click here to see videos.

This is an open letter to the economics, finance and banking communities. I don’t have any dog in the fight, other than to figure out and then publicize what is best for the greatest number of people. People I greatly respect advocate for federal-level public banking, state public banks or a return to the gold standard. I am simply attempting to start a high-level debate about what the best option is.

Please see responses posted by economists and others below.  I will update the responses as I receive them.

How Is Credit Created?

I pointed out in September:

As PhD economist Steve Keen pointed out recently, 2 Nobel-prize winning economists have shown that the assumption that reserves are created from excess deposits is not true:

The model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.

The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic variables, they found that credit money was created about 4 periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.

Kydland and Prescott observed at the end of their paper that:

Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

In other words, if the conventional view that excess reserves (stemming either from customer deposits or government infusions of money) lead to increased lending were correct, then Kydland and Prescott would have found that credit is extended by the banks (i.e. loaned out to customers) after the banks received infusions of money from the government. Instead, they found that the extension of credit preceded the receipt of government monies.

Keen explained in an interview Friday that 25 years of research shows that creation of debt by banks precedes creation of government money, and that debt money is created first and precedes creation of credit money.

As Mish has previously noted:

Conventional wisdom regarding the money multiplier is wrong. Australian economist Steve Keen notes that in a debt based society, expansion of credit comes first and reserves come later.

This angle of the banking system has actually been discussed for many years by leading experts:

“[Banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers’ transaction accounts.”
- 1960s Chicago Federal Reserve Bank booklet entitled “Modern Money Mechanics”

“The process by which banks create money is so simple that the mind is repelled.”
- Economist John Kenneth Galbraith

“[W]hen a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposit; it was not previously paid in to the bank by anyone. It’s new money, created by the bank for the use of the borrower.”
- Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

“Do private banks issue money today? Yes. Although banks no longer have the right to issue bank notes, they can create money in the form of bank deposits when they lend money to businesses, or buy securities. . . . The important thing to remember is that when banks lend money they don’t necessarily take it from anyone else to lend. Thus they ‘create’ it.”
-Congressman Wright Patman, Money Facts (House Committee on Banking and Currency, 1964)

“The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented.”
- Sir Josiah Stamp, president of the Bank of England and the second richest man in Britain in the 1920s.

“Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created — brand new money.”
- Graham Towers, Governor of the Bank of Canada from 1935 to 1955.

I’ve also noted:

In First National Bank v. Daly (often referred to as the “Credit River” case) the court found that the bank created money “out of thin air”:

[The president of the First National Bank of Montgomery] admitted that all of the money or credit which was used as a consideration [for the mortgage loan given to the defendant] was created upon their books, that this was standard banking practice exercised by their bank in combination with the Federal Reserve Bank of Minneaopolis, another private bank, further that he knew of no United States statute or law that gave the Plaintiff [bank] the authority to do this.

The court also held:

The money and credit first came into existence when they [the bank] created it.

(Here’s the case file).

Justice courts are just local courts, and not as powerful or prestigious as state supreme courts, for example. And it was not a judge, but a justice of the peace who made the decision.

But what is important is that the president of the First National Bank of Montgomery apparently admitted that his bank created money by simply making an entry in its book …

Moreover, although it is counter-intuitive, virtually all money is actually created as debt. For example, in a hearing held on September 30, 1941 in the House Committee on Banking and Currency, then-Chairman of the Federal Reserve (Mariner S. Eccles) said:

That is what our money system is. If there were no debts in our money system, there wouldn’t be any money.

And Robert H. Hemphill, Credit Manager of the Federal Reserve Bank of Atlanta, said:

If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is. It is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon.

This must-see 47 minute video provides details:

So here are the first two questions:

Do you agree that banks create credit by initiating loans, and then obtaining deposits subsequently, to comply with depository requirements? I’m not talking about the coins which governments create (in America, coins represent less than 5% of the total money in circulation).

Do you agree with Eccles and Hemphill that money is debt, in that new credit normally comes into existence when a new loan is issued?

Government Alternative

William Greider is a former Washington Post and Rolling Stone editor, and now writes for the Nation. Greider has written numerous books and articles on the economy over the course of many decades, including one of the leading books on the Federal Reserve, Secrets of the Temple.

In an article in the Nation, Greider argues that the government could solve the economic crisis by taking back the power of money creation from the banks and the Federal reserve:

For the first time in generations, [the Fed is] now threatened with popular rebellion.

During the past year, the Fed has flooded the streets with money–distributing trillions of dollars to banks, financial markets and commercial interests …

Where did the central bank get all the money it is handing out? Basically, the Fed printed it, out of thin air. That is what central banks do. Who told the Fed governors they could do this? Nobody, really–not Congress or the president. The Federal Reserve Board, alone among government agencies, does not submit its budgets to Congress for authorization and appropriation. It raises its own money, sets its own priorities.

Representative Wright Patman, the Texas populist who was a scourge of central bankers, once described the Federal Reserve as “a pretty queer duck.” Congress created the Fed in 1913 with the presumption that it would be “independent” from the rest of government, aloof from regular politics and deliberately shielded from the hot breath of voters or the grasping appetites of private interests–with one powerful exception: the bankers…

Banks are the “shareholders” who ostensibly own the twelve regional Federal Reserve banks…

The Federal Reserve is the black hole of our democracy–the crucial contradiction that keeps the people and their representatives from having any voice in these most important public policies. That’s why the central bankers have always operated in secrecy, avoiding public controversy and inevitable accusations of special deal-making. The current crisis has blown the central bank’s cover…

Altering the central bank would also give Congress an opening to reclaim its primacy in this most important matter. That sounds farfetched to modern sensibilities, and traditionalists will scream that it is a recipe for inflationary disaster. But this is what the Constitution prescribes: “The Congress shall have the power to coin money [and] regulate the value thereof.” It does not grant the president or the treasury secretary this power. Nor does it envision a secretive central bank that interacts murkily with the executive branch…

If Ben Bernanke can create trillions of dollars at will and spread them around the financial system, could government do the same thing to finance important public projects the people want and need? Daring as it sounds, the answer is, Yes, we can.

The central bank’s most mysterious power–to create money with a few computer keystrokes–is dauntingly complicated, and the mechanics are not widely understood. But the essential thing to understand is that this power relies on democratic consent–the people’s trust, their willingness to accept the currency and use it in exchange. This is not entirely voluntary, since the government also requires people to pay their taxes in dollars, not euros or yen. But citizens conferred the power on government through their elected representatives. Newly created money is often called the “pure credit” of the nation. In principle, it exists for the benefit of all];

In this emergency, Bernanke essentially used the Fed’s money-creation power in a way that resembles the “greenbacks” Abraham Lincoln printed to fight the Civil War. Lincoln was faced with rising costs and shrinking revenues (because the Confederate states had left the Union). The president authorized issuance of a novel national currency–the “greenback”–that had no backing in gold reserves and therefore outraged orthodox thinking. But the greenbacks worked. The expanded money supply helped pay for war mobilization and kept the economy booming. In a sense, Lincoln won the war by relying on the “full faith and credit” of the people, much as Bernanke is printing money freely to fight off financial collapse and deflation.

If Congress chooses to take charge of its constitutional duty, it could similarly use greenback currency created by the Federal Reserve as a legitimate channel for financing important public projects–like sorely needed improvements to the nation’s infrastructure. Obviously, this has to be done carefully and responsibly, limited to normal expansion of the money supply and used only for projects that truly benefit the entire nation (lest it lead to inflation). But here is an example of how it would work…

Instead, Congress should create a stand-alone development fund for long-term capital investment projects (this would require the long-sought reform of the federal budget, which makes no distinction between current operating spending and long-term investment). The Fed would continue to create money only as needed by the economy; but instead of injecting this money into the banking system, a portion of it would go directly to the capital investment fund, earmarked by Congress for specific projects of great urgency. The idea of direct financing for infrastructure has been proposed periodically for many years by groups from right and left…

This approach speaks to the contradiction House Speaker Pelosi pointed out when she asked why the Fed has limitless money to spend however it sees fit. Instead of borrowing the money to pay for the new rail system, the government financing would draw on the public’s money-creation process–just as Lincoln did and Bernanke is now doing.

The bankers would howl, for good reason. They profit enormously from the present system and share in the money-creation process. When the Fed injects more reserves into the banking system, it automatically multiplies the banks’ capacity to create money by increasing their lending (and banks, in turn, collect interest on their new loans). The direct-financing approach would not halt the banking industry’s role in allocating new credit, since the newly created money would still wind up in the banks as deposits. But the government would now decide how to allocate new credit to preferred public projects rather than let private banks make all the decisions for us.

Here are my third, fourth and fifth questions:

Do you agree with Greider that the American Constitution and/or the inherent right of sovereign nations gives the government the power and authority to itself create credit?

Do you agree with Greider that such government creation of credit need not be inflationary so long as only as much credit is created as is needed by the economy – in other words, the amount actually needed to buy goods and services?

Several monetary commentators have said that – if credit is created primarily by the government instead of private banks – that it would save the government trillions of dollars in interest. Specifically, they claim that private banks charge interest to the government to fund the government’s debt, but that the government would owe no debt on credit it creates itself.

Is that true?

What Is the Best Public Banking Option?

As I wrote in November:

AFL-CIO president Richard Trumka told Congress last week:

If the Federal Reserve were made a fully public body, it would be an acceptable alternative.

The American Monetary Institute proposes the following alternative:

Incorporate the Federal Reserve System into the U.S. Treasury where all new money would be created by government as money, not interest-bearing debt; and be spent into circulation to promote the general welfare. The monetary system would be monitored to be neither inflationary nor deflationary.

Second, halt the bank’s privilege to create money by ending the fractional reserve system in a gentle and elegant way.

All the past monetized private credit would be converted into U.S. government money. Banks would then act as intermediaries accepting savings deposits and loaning them out to borrowers. They would do what people think they do now. This Act nationalizes the money system, not the banking system.

Bloomberg News columnist Matthew Lynn writes:

The U.K. government needs to start thinking about what it will do with all the banks it now owns. The answer is simple: Hand them to the people…

Instead of selling the stakes it acquired in the financial system to other banks, or listing the shares on the stock market, it could create mutually owned societies. Royal Bank of Scotland Group Plc could be a people’s bank, owned by everyone.That would ensure more diversity, competition and stability, all goals just as worthy as getting back the money Prime Minister Gordon Brown’s government spent on bank rescues…

Sovereign nations such as the U.S. and England have the power to create credit and money (and see this, this and this). Taking the credit-creation power away from the banks and giving it back to the nation would ensure that credit is freed up for people’s use, and the stranglehold over the economy is taken away from the too big to fails.

State Public Banks

Many people argue that – given its actions – people don’t trust the federal government to create money.

Fair enough. Why not let the states do it?

Michael Moore recommends that the American people demand:

Each of the 50 states must create a state-owned public bank like they have in North Dakota. Then congress MUST reinstate all the strict pre-Reagan regulations on all commercial banks, investment firms, insurance companies — and all the other industries that have been savaged by deregulation: Airlines, the food industry, pharmaceutical companies — you name it. If a company’s primary motive to exist is to make a profit, then it needs a set of stringent rules to live by — and the first rule is “Do no harm.” The second rule: The question must always be asked — “Is this for the common good?” (Click here for some info about the state-owned Bank of North Dakota.)

As Moore notes, the state of North Dakota already has such a bank, and – because of that – North Dakota is just about the only state which is not running a huge deficit.

PhD economist and candidate for Florida governor Farid Khavari wants to create a Bank of the State of Florida, to create credit without burdening the state and its citizens with high interest charges by private banks.

See this for details.

Local Public Banks

An alternative to federal or state public banking is local public banks, as proposed by Edward Kellogg and others.

As summarized by Adrian Kuzminski:

During this time of financial and economic crisis, it is worth recalling that credible alternatives to our current financial system exist, if largely unrecognized, and deserve serious consideration…

The now-neglected 19th-century American proto-populist, Edward Kellogg … was a kind of godfather to the later populist movement on monetary issues. Perhaps the most profound of American writers on monetary issues, Kellogg advocated a decentralized but nationally regulated monetary system based on non-usurious, low-interest public loans to individuals. His vision inspired 19th-century century mutualists, greenbackers, populists, and others who sought to restructure the monetary system to redistribute wealth.

In our own day, when usurious credit in the form of private finance capital remains the dominant force in economic life, and is largely taken for granted even by educated people, the alternative Kellogg offers is more important than ever. Indeed, I suggest that Kellogg’s theory of money is the best monetary alternative we have to the baleful system under which we suffer…

Edward Kellogg (1790-1858) was a New York City businessman whose losses in the crash of 1837 led him to examine the business cycle, monetary policy, and debt. In a series of writings, Kellogg developed the idea of … having the government provide very-low-interest loans to the general public. These loans would have a uniform, fixed interest rate, established by law. They would be issued locally through a system of public credit banks he called the Safety Fund. Once issued, these low-interest loan notes would circulate as currency, replacing the privately issued banking notes of his day (which today take the form of Federal Reserve Notes)…

In his day Kellogg seems to have influenced even Abraham Lincoln who, according to historian Mark A. Lause, ” . . . had his own copy of Kellogg’s book, Labor and Capital [sic] advocating the government issuance of paper currency as a just means of redistributing wealth, and he corresponded with the author’s son-in-law.” Kellogg’s public currency was intended to end the monopoly over the discretionary issuance of money at interest, which was held then (and now) by the private banking and investment system…

Kellogg proposed to establish local public credit banks, and we might imagine one in each community. These local public credit banks would be part of the Safety Fund. Instead of money being issued (as it is now) through a privatized and centralized money-management system on a top-down basis, primarily as loans at increasing rates of interest from a central bank to major commercial banks, and then to regional and local banks, and then to the public, money in his system would be issued by local federal banks as loans directly to citizens at nominal interest on the basis of their economic prospects. Once lent out, Kellogg’s public credit notes would flow into circulation, providing the basis for a new currency backed by the assets of individual borrowers…

A centralized national currency would be replaced, in Kellogg’s system, by a locally issued currency. But that currency would everywhere be subject to common national standards, ensuring that each local public credit bank reliably issued equivalent units of currency. A dollar issued by one local public credit bank of the Safety Fund, Kellogg intended, would be worth the same as, and be freely interchangeable with, one issued by any other. The independence of local branches would be guaranteed by the discretionary power reserved to them as a local monopoly actually to loan money; the compatibility of their monies would be ensured under federal law by fixing the value of the dollar by law at 1.1 percent/year – that is, by lending money everywhere to citizens at that rate…

The goal is to establish and preserve economic decentralization. Amounts of money lent in Kellogg’s system would vary considerably from place to place, with some areas needing and creating more currency than others. The solvency of local federal public credit banks would be guaranteed by collateral put up by borrowers, and the money supply would be stabilized by repayment of loans as they came due. The interchangeability of public credit bank notes would ensure a wide circulation for the new money…

To achieve a stable currency, Kellogg insisted that this rate be fixed by law; perhaps today it would take a constitutional amendment.

Michael Hudson (Distinguished Research Professor at the University of Missouri, Kansas City, who has advised the U.S., Canadian, Mexican and Latvian governments as well as the United Nations Institute for Training and Research. He is a former Wall Street economist at Chase Manhattan Bank who also helped establish the world’s first sovereign debt fund) and Congressman Dennis Kucinich both support the federal public banking option:

On the other hand, California considered creation of a state bank modeled after North Dakota’s bank in 1977. And the Massachusetts state Senate is currently considering creation of a state public bank, and other states are currently considering creating their own state banks.

So here is my sixth question:

Do you think a federal, state or local public banking option is best?

What About Gold?

Advocates for a return to the gold standard point out that – when a currency is pegged to a hard asset such as gold – it imposes fiscal discipline. Specifically, the government cannot simply run its “printing press” if its currency has to maintain a set ratio to a hard asset, and this prevents funding of endless wars and other misadventures.

Advocates for public banking, on the other hand, point to the numerous depressions which have occurred during periods when the gold standard was in place.

See these short videos (I don’t necessarily agree with the conspiracy theories alleged in the first video, but only with the general question of whether we can assure that the quantity and quality of gold can be assured):

Here is my seventh and final question:

Is there any way to have a hybrid monetary system which provides the benefits of public banking with the fiscal discipline which something like a gold standard imposes?

Responses to This Essay

Steve Keen is an Associate Professor in economics and finance at the University of Western Sydney. He identifies as post-Keynesian, criticizing both modern neoclassical economics and (some of) Marxian economics as inconsistent, unscientific and empirically unsupported. The major influences on Keen’s thinking about economics include Hyman Minsky, Piero Sraffa and Joseph Alois Schumpeter. His recent work mostly concentrates on mathematical modeling and simulation of financial instability. Keen writes at DebtDeflation.com/blogs

Keen responds:

I obviously see the need to reform the financial system, but my analysis of how credit is created (see my “Roving Cavaliers of Credit” post: http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/) makes me sceptical that any new system will “hold” so long as financiers can make money by financing asset-price speculation. I believe the experience of history should tell us that every system we’ve tried to far has finally succumbed to a debt-financed asset-price bubble, whose bursting has brought in at best a recession and at worst a Depression.

I have therefore developed proposals to tackle the root problem from the other side of the ledger: if financiers can always be expected to exploit the desire of borrowers to speculate on rising asset prices, then we have to remove that desire in the first place.

The most effective way to do this would be to redesign assets in a manner that still encouraged individual ownership and enterprise, but made the prospects of leveraged gains on asset speculation much less likely.

My two proposals are: to modify shares so that once they are on the secondary market they expire after a predefined period (say 25 years); and to limit the maximum leverage that can be secured against a property to some multiple (say 10) of the property’s annual rental income.

Explaining these in more detail:

Shares

Shares purchased in an initial public offering or float would last indefinitely while held by the original purchaser. But once these shares were sold, they would have a defined life of (say) 25 years.

This would have several benefits over our current system:

(1) Purchasers of shares on the secondary market would be forced to do what the Capital Assets Pricing Model (the delusional neoclassical theory that dominated academic finance prior to the GFC) pretended they do now: to value shares on a sensible valuation of expected future dividend earnings. You would only buy a share under this system if you expected a reasonably good stream of dividends from it, because in 25 years it would expire; and

(2) It would encourage the act of providing finance to new ventures. At present, the share market does a very poor job of providing new finance, with over 99% of the transactions being secondary market sales in search of capital gains. With my change, the only way to secure an indefinite stream of revenue from a new venture would be to provide it with some of its initial capital. This proposal would drastically shift the balance in favour of raising initial capital, which is the only truly socially beneficial role of the stock market.

Property

The great danger with the current system is that there is a positive feedback loop between property prices and leverage. An increase in leverage allows a purchaser to bid a higher price for a property, which encourages other purchasers to come in with higher leverage again with the intention of profiting from selling on a rising market. This is the basic mechanism that led to the Subprime Crisis.

If instead there were a maximum allowed level of leverage based on the income-earning potential of the property being purchased, then an increase in price would cause a reduction in leverage: if a purchaser truly wanted a given property and was willing to pay more than ten times the annual rental income to secure it, then he/she would necessarily have to use unleveraged funds to do so, and the increase in price would cause a reduction in leverage.

Stability

The real problem with other proposals–such as government-created credit, etc.–is that without reform to the way we define capital assets, this money can still be used to speculate on asset prices. This can lead to asset bubbles, and those who are successful in them will gain money and the power that comes with it. They will then be in a position to lobby for the unwinding of the reforms that were enacted during the crisis–as we have seen in our own lifetimes with the abolition of almost all the Great Depression era legislation in the leadup to the GFC.

This proposal would limit that prospect by preventing the formation of the class of Ponzi Financiers in the first instance. This to me is the real lesson of financial history: every crisis is caused by debt, the debt is taken on by Ponzi Financiers who then accumulate the economic and political power to reshape the system to suit themselves, leading to its inevitable collapse. We have to stop the Ponzis at the source, and the source is the potential for leveraged gain on asset prices.

By Frank Partnoy, Professor of Law and Finance University of San Diego School of Law and author of Fiasco, Infectious Greed, and The Match King

The buzz on the Lehman bankruptcy examiner’s report has focused on Repo 105, for good reason. That scheme is one powerful example of how the balance sheets of major Wall Street banks are fiction. It also shows why Congress must include real accounting reform in its financial legislation, or risk another collapse. (If you have 8 minutes to kill, here is my recent talk on the off-balance sheet problem, from the Roosevelt Institute financial conference.)

But an even more troubling section of the Lehman report is not Volume 3 on Repo 105. It is Volume 2, on Valuation. The Valuation section is 500 pages of utterly terrifying reading. It shows that, even eighteen months after Lehman’s collapse, no one – not the bankruptcy examiner, not Lehman’s internal valuation experts, not Ernst and Young, and certainly not the regulators – could figure out what many of Lehman’s assets and liabilities were worth. It shows Lehman was too complex to do anything but fail.

The report cites extensive evidence of valuation problems. Check out page 577, where the report concludes that Lehman’s high credit default swap valuations were reasonable because Citigroup’s marks were ONLY 8% lower than Lehman’s. 8%? And since when are Citigroup’s valuations the objective benchmark?

Or page 547, where the report describes how Lehman’s so-called “Product Control Group” acted like Keystone Kops: the group used third-party prices for only 10% of Lehman’s CDO positions, and deferred to the traders’ models, saying “We’re not quants.” Here are two money quotes:

While the function of the Product Control Group was to serve as a check on the
desk marks set by Lehman’s traders, the CDO product controllers were hampered in
two respects. First, the Product Control Group did not appear to have sufficient
resources to price test Lehman’s CDO positions comprehensively. Second, while the
CDO product controllers were able to effectively verify the prices of many positions
using trade data and third‐party prices, they did not have the same level of quantitative sophistication as many of the desk personnel who developed models to price CDOs. (page 547)

Or this one:

However, approximately a quarter of Lehman’s CDO positions were not affirmatively priced by the Product Control Group, but simply noted as ‘OK’ because the desk had already written down the position significantly. (page 548)

My favorite section describes the valuation of Ceago, Lehman’s largest CDO position. My corporate finance students at the University of San Diego School of Law understand that you should use higher discount rates for riskier projects. But the Valuation section of the report found that with respect to Ceago, Lehman used LOWER discount rates for the riskier tranches than for the safer ones:

The discount rates used by Lehman’s Product Controllers were significantly understated. As stated, swap rates were used for the discount rate on the Ceago subordinate tranches. However, the resulting rates (approximately 3% to 4%) were significantly lower than the approximately 9% discount rate used to value the more senior S tranche. It is inappropriate to use a discount rate on a subordinate tranche that is lower than the rate used on a senior tranche. (page 556)

It’s one thing to have product controllers who aren’t “quants”; it’s quite another to have people in crucial risk management roles who don’t understand present value.

When the examiner compared Lehman’s marks on these lower tranches to more reliable valuation estimates, it found that “the prices estimated for the C and D tranches of Ceago securities are approximately one‐thirtieth of the price reported by Lehman. (pages 560-61) One thirtieth? These valuations weren’t even close.

Ultimately, the examiner concluded that these problems related to only a small portion of Lehman’s overall portfolio. But that conclusion was due in part to the fact that the examiner did not have the time or resources to examine many of Lehman’s positions in detail (Lehman had 900,000 derivative positions in 2008, and the examiner did not even try to value Lehman’s numerous corporate debt and equity holdings).

The bankruptcy examiner didn’t see enough to bring lawsuits. But the valuation section of the report raises some hot-button issues for private parties and prosecutors. As the report put it, there are issues that “may warrant further review by parties in interest.”

For example, parties in interest might want to look at the report’s section on Archstone, a publicly traded REIT Lehman acquired in October 2007. Much ink has been spilled criticizing the valuation of Archstone. Here is the Report’s finding (at page 361):

… there is sufficient evidence to support a finding that Lehman’s valuations for its Archstone equity positions were unreasonable beginning as of the end of the first quarter of 2008, and continuing through the end of the third quarter of 2008.

And Archstone is just one of many examples.

The Repo 105 section of the Lehman report shows that Lehman’s balance sheet was fiction. That was bad. The Valuation section shows that Lehman’s approach to valuing assets and liabilities was seriously flawed. That is worse. For a levered trading firm, to not understand your economic position is to sign your own death warrant.

Apologies for thin posts, but the time change (did you reset your clocks?) and the book chat (see preceding post, we went nearly three hours) cut into my blogging time in a major way.

In pictures: Bear power BBC

The greatest film scenes ever shot Guardian. One of my favorites is nowhere to be found: the opening sequence from Yojimbo.

Hadrian’s Wall lit by “line of light” Telegraph

Demon Sheep Ad Man Strikes Again, Morphs Boxer Into A Blimp Huffington Poat

Pharma faces a character count conundrum Spoonful of Medicine. WTF? Drugs are now being marketed via Twitter?!?

Clinton rebukes Israel over new settlements Financial Times. The story is much more damning than its anodyne headline suggests.

Hearts may swoon when stocks do, study suggests PhysOrg

In Hard Times, Lured Into Trade School and Debt New York Times

Lehman as Enron 2.0 Archein

Welcome to America, Sucker Andy Kroll, TomDispatch

Private Equity’s Trojan Horse of Debt Gretchen Morgenson, New York Times. In case you wondered why the EU wants to keep US PE firms out. Morgenson is not indignant enough.

Wrong Surprise on Retail Sales Beat the Press

US Public Debt watch update One Salient Oversight

LA Area Port Traffic in February Calculated Risk

China’s Wen Rebuffs Yuan Calls, Opposes ‘Finger Pointing’ Bloomberg and Tensions escalate over China’s currency Financial Times. This is looking more serious, but given Team Obama’s track record, the odds of a climbdown are very high.

Antidote du jour (hat tip reader Gary P):

This is self-taught. Every once in a while, Jake will scour the house, gathering up all his possessions, then carry them around, showing them off to the rest of the family.

I think of him as our Canine Capitalist.

I chatted at the Book Salon on FireDogLake on Saturday (yes I screwed up completely in not notifying Naked Capitalism readers). The conversation was hosted by masaccio and led to a wide ranging discussion.

The chat started with his summary of the book:

Yves Smith brings the same clear and concise writing to ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, her explanation of the Great Crash of 2008, that she shows every day at her website Naked Capitalism. Smith points to the abject failure of neoclassical economics as the beginning point for this disaster. The unproven assumptions of this theory were converted into Indubitable Truth by academic economists. Their careers were based on their ability to combine those Indubitable Truths with other unproven assumptions and turn them into mathematical formulas which, they said, explained the way the economy works. These ideas were widely accepted by corporate interests and their shills and think tanks, media elites and politicians, and turned into statutes and regulatory policy. Immediately the vipers on Wall Street exploited every one of the new weaknesses for personal profit, first at the expense of other traders, then at the expense of their own clients, and finally at the expense of taxpayers.

The session continues here. Enjoy!

A Game of Tag Breaks Out Between London’s Graffiti Elite Wall Street Journal (hat tip reader Lance)

Climate linked to smaller birds BBC

The Dollar, the Deficit, and Accounting Identities Dean Baker

Fragile riches Rolfe Winkler

CSI Lehman-Barclays: Who Really Killed the September 2008 Deal? WSJ Deal Journal. Note the examiner’s report suggests that the FSA did not kill the Lehman deal; rather it set criteria as early as Sept. 10 and was never presented with a deal.

U.S., Europe at odds over global financial reform Washington Post. Pure Treasury PR.

Are Shipping Numbers Masking A Stealth Commodities Selloff? Clusterstock

Robert Reich: The Sham Recovery Huffington Post

The German Finance Minister Needs To Confront Investment Banks Simon Johnson

China May Face ‘Massive’ Bank Bailouts After Stimulus Program Bloomberg

Centrally Planned Suburbia Matt Yglesias

‘Apartheid’ call system filters out poor Barclays clients Daily Mail (hat tip reader Steve L)

Mortgage lending falls as buyers leave market Times Online

Not Durable? Michael Panzner

Antidote du jour:

From the December 2009 issue of The Baffler (no online version of this article available). For those not familiar with The Baffler, this is the revival of a magazine of business and culture edited by Thomas Frank that had previously been published from 1988 to 2007. This issue was called “Margin Call” and included articles by Matt Taibbi, Naomi Klein, Michael Lind. I believe readers will find this piece to be relevant. Enjoy!

Since inequalities of privilege are greater than could possibly be defended rationally, the intelligence of privileged groups is usually applied to the task of inventing specious proofs for the theory that universal values spring from, and that general interests are served by, the special privileges which they hold.

Reinhold Niebuhr, Moral Man and Immoral Society

A year on from its brush with Armageddon, the financial services industry has resumed its reckless, self-serving ways It isn’t hard to see why this has aroused simmering rage in normally complacent, pro-capitalist Main Street America. The budget commitments to salvaging the financial sector come to nearly $3 trillion, equivalent to more than $20,000 per federal income tax payer. To add insult to injury, the miscreants have also availed themselves of more welfare programs in the form of lending facilities and guarantees, totaling nearly $12 trillion, not all of which will prove to be money well spent.

Wall Street just looted the public on a massive scale. Having found this to be a wondrously lucrative exercise, it looks set to do it all over again.

These people above all were supposed to understand money, the value of it, the risks attendant with it. The industry broadly defined, even including once lowly commercial bank employees, profited handsomely as the debt bubble grew. Compensation per worker in the early 1980s was similar to that of all non-government employees. It started accelerating in 1983, and hit 181 percent of the level of private sector pay by 2007. The rewards at the top were rich indeed. The average employee at Goldman Sachs made $630,000 in 2007. That includes everyone, the receptionists, the guys in the mail room, the back office staff. Eight-figure bonuses for big producers became standard in the last cycle. And if the fourth quarter of 2009 proves as lucrative as the first three, Goldman’s bonuses for the year will exceed bubble-peak levels.

The rationale for the eye-popping rewards was simple. We lived in a Brave New World of finance, where the ability to slice, dice, repackage and sell risk led to better outcomes for all, via cheaper credit and better diversification. We have since learned that this flattering picture was a convenient cover for massive risk-taking and fraud. The industry regularly bundled complicated exposures into products and dumped them onto investors who didn’t understand them. Indeed, it has since become evident that the industry itself didn’t understand them. The supposedly sophisticated risk management techniques didn’t work so well for even the advanced practitioners, as both top investment banks and quant hedge funds hemorrhaged losses. And outside the finance arena, the wreckage is obvious: housing market plunges in the U.S., UK, Ireland, Spain, the Baltics and Australia; a steep decline in trade; a global recession with unemployment in the U.S. and elsewhere hitting highs not seen in more than 25 years, with the most accurate forecasters of the calamity intoning that the downturn will be protracted and the recovery anemic.

With economic casualties all about, thanks to baleful financial “innovations” and reckless trading bets, the tone-deafness of the former Masters of the Universe is striking. Their firms would have been reduced to sheer rubble were it not for the munificence of the taxpayer—or perhaps, more accurately, the haplessness of the official rescuers, who threw money at these players directly and indirectly, through a myriad a programs plus the brute force measure of super low interest rates, with perilous few strings attached.

Yet what is remarkable is that the widespread denunciations of excessive banking industry pay are met with incredulity and outright hostility. It’s one thing to be angry over a reversal in fortune; it’s one of the five stages of grief. But the petulance, the narcissism, the lack of any sense of proportion reveals a deep-seated pathology at work.

Exhibit A is the resignation letter of one Jake DeSantis, an executive vice president in AIG’s Financial Products unit, tendered in March 2009 as outcry over bonuses paid to executives of his firm reached a fever pitch. The New York Times ran it as an op-ed. “I am proud of everything I have done,” DeSantis wrote.

I was in no way involved in—or responsible for—the credit default swap transactions that have hamstrung A.I.G. Nor were more than a handful of the 400 current employees of A.I.G.-F.P. Most of those responsible have left the company and have conspicuously escaped the public outrage….

[W]e in the financial products unit have been betrayed by A.I.G. and are being unfairly persecuted by elected officials.…

I take this action after 11 years of dedicated, honorable service to A.I.G. … The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money. I did, however, like many others here, lose a significant portion of my life savings in the form of deferred compensation invested in the capital of A.I.G.-F.P. because of those losses.

Anyone with an operating brain cell could shred the logic on display here. AIG had imploded, but unlike a normal failed business, it left a Chernobyl-scale steaming hulk that needed to be hermetically sealed at considerable cost to taxpayers. Employees of bankrupt enterprises seldom go about chest-beating that they did a good job, it was the guys down the hall who screwed up, so they therefore still deserve a fat bonus check. That line of reasoning is delusional, yet DeSantis had no perspective on it. And there is the self-righteous “honorable service,” which casts a well-paid job in the same terms as doing a tour of duty in the armed forces, and the hyperventilating: “proud,” “betrayed,” “unfairly persecuted,” “clearly supported.”

And to confirm the yawning perception gap, the letter was uniformly vilified in the Times’ comment section, but DeSantis’s colleagues gave him a standing ovation when he came to the office.

The New York press has served as an occasional outlet for this type of self-righteous venting. Some sightings from New York Magazine:

[I]f someone went to Columbia or Wharton, [even if] their company is a fumbling, mismanaged bank, why should they all of a sudden be paid the same as the guy down the block who delivers restaurant supplies for Sysco…?

I’m attached to my BlackBerry. … I get calls at two in the morning. … That costs money. If they keep compensation capped, I don’t know how the deals get done.

It never seems to occur to them, as Clemenceau once said, that the graveyards are full of indispensable men. So if the cohort with glittering resumes no longer deems the pay on offer sufficiently motivating for them to get out of bed, guess what? People with less illustrious pedigrees will gladly take their places.

And the New York Times has itemized how the math of a successful banker lifestyle (kids in private school, Upper East Side co-op, summer house in Hamptons) simply doesn’t work on $500,000 a year. Of course, it omitted to point out that outsized securities industry pay was precisely what escalated the costs of what was once a mere upper-middle-class New York City lifestyle to a level most people would deem stratospheric.

Although the word “entitlement” fits, it’s been used so frequently as to have become inadequate to capture the preening self-regard, the obliviousness to the damage that high-flying finance has inflicted on the real economy, the learned blindness to vital considerations in the pay equation. Getting an education, or even hard work, does not guarantee outcomes. One of the basic precepts of finance is that of a risk-return tradeoff: high potential payoff investments come with greater downside.

But how did that evolve into the current belief system among the incumbents, that Wall Street was a sure ride, a guaranteed “heads I win, tails you lose” bet? The industry has seen substantial setbacks—the end of fixed commissions in 1975, which led to business failures and industry consolidation, followed by years of stagflation, punitive to financial assets and securities industry earnings; the aftermath of savings and loan crisis, which saw employment in mergers and acquisitions contract by 75 percent; the dot-com bust, which saw headhunters inundated with resumes of former high fliers. Those who still had jobs were grateful be employed, even if simultaneously unhappy find themselves diligently tilling soil in a drought year, certain to reap a meager harvest.

But you never heard any caviling about how awful it was to have gone, say, from making $2 or $3 million to a mere $400,000 (notice how much lower the prevailing peak numbers were in recent cycles). And if you were having trouble paying your expenses, that was clearly bad planning. Everyone knew the business was volatile. Indeed, the skimpy salaries once served as a reminder that nothing was guaranteed.

So why the unseemly whining? It’s a symptom of longstanding pathologies in the industry that were once narrowly useful but which have gotten wildly out of hand.

It wasn’t always that way. I worked for a few years in the early 1980s in investment banking at Goldman Sachs, and later in the decade starting up the M&A business for a Japanese bank, then the second largest in the world, in that brief window when the island nation seemed to be buying up America. I have continued to consult to the industry.

Unfortunately, it isn’t hard to see how those on the investment banking meal ticket come to have an unduly high opinion of their worth.

Wall Street jobs have long been the prime objective at the top of the MBA food chain, and that has always been a function of the money. Aside from looking for people who are well groomed, articulate and reasonably numerate (image is important, given the fees charged to corporate clients), firms screen job candidates for money orientation and what is politely called drive. At Goldman, the word “aggressive” was used frequently a term of approbation.

But the firms are white-collar sweatshops with glamorous trappings. You do not know how hard you can work, short of slavery, unless you have been an investment banking analyst or associate. It is not merely the hours, but the extreme and unrelenting time pressure. Priorities are revised every day, numerous times during the day, as markets move. You have many bosses, each with independent demands and deadlines, and none cares what the others want done when. You are not allowed to say no to unreasonable demands. The sense of urgency is so great that waiting for an elevator is typically agonizing. If you manage to get your bills paid and your laundry done, you are managing your personal life well. Exhaustion is normal. On a quick run home en route to the airport after an all-nighter, a co-worker tried to shower fully clothed.

A setting that would seem to reward, nay require, cutting corners has another striking feature: intolerance for error. A computation mistake or a typo in a client document is a career-limiting event. Minor miscues undercut the notion that your firm can execute the more complex and risky elements correctly

And the dynamic doesn’t change much over the course of one’s career. The drill of being a medical resident (or pre-Iraq, a tour of duty) has a known endpoint. But investment bankers have signed a Faustian contract: You have no right to personal boundaries. The business says how high to jump, and you are expected to deliver. Yes, more senior people have more dignity, but the idea that your needs are second to those of the business never changes.

In my day, it wasn’t uncommon for the firm to ask associates to reschedule weddings if they conflicted with a deal. It wasn’t that firms were opposed to marriage; indeed, the partners knew a young man was theirs once he procured a wife and, better yet, kids. He was tied hopelessly into a personal overhead structure that would keep him in the business.

Not that there was any real risk that someone would leave voluntarily. Exhaustion and loss of personal boundaries are an ideal setting for brainwashing, which is why people who have spent much of their career in finance have such difficulty understanding why their firm and their worldview might not be the center of the universe, why they might not be deserving of their outsized pay.

The finance community has other elements in common with cults. One is the implicit and explicit reinforcement of bankers’ “specialness,” their elite status. In how many lines of work do you get to meet with CEOs at a tender age, much less work on matters where hundreds of millions, often billion, are routine? Senior people in the investment banks are political fundraising heavyweights and sit on high-prestige nonprofit boards. Anyone of a Calvinist persuasion would be impressed.

Another parallel to cult indoctrination is that the demands of the job remove new hires from established friends and family and plunge them into a new environment. Most people who come to Wall Street are not New York natives, and the extreme and erratic hours make it difficult to maintain old ties. Season tickets are likely to be given away. Vacations (save for the week before Labor Day and the Christmas-New Year’s period) are frequently rescheduled.

Class consciousness is felt nowhere more keenly than in the world of high finance. Wall Street denizens earn more money than most people—that’s the point, after all. And that means they become accustomed to the perks, such as eating at restaurants that might strain the budget of those less well situated. And, frankly, with their lives revolving around finance and business, other interests wither. In most cases, it’s more fun for them to talk shop than to relate to people outside their cloistered world. The incestuousness often extends to one’s personal life. When I was at Goldman, the only married women professionals who were not married to men at Goldman had come to the firm hitched.

These values become deeply internalized. One buddy, a vice president in hard-charging, testosterone-filled M&A, spent the better part of a weekend lying on her side on the floor of her office, reading deal documents. She kept reassuring concerned colleagues that she was fine, until the pain got so bad that she relented and called her boyfriend. He came and took her straight to the hospital. The doctors operated immediately, assuming she had appendicitis. They found instead diverticulitis, which usually afflicts the elderly, and she was so close to a colon rupture that they had to remove half of it.

The partners at her firm instructed her to not to return until she had recovered fully. But this was September. Bonuses were paid at year end, and as she read the unwritten code, and knew that staying away too long would be seen as a sign of weakness. She was back at the office three weeks later, looking wan.

She later became the first woman investment banking partner at her prestigious firm. Her instincts served her well. Or maybe not. She later lost 90 percent of the vision in one eye to glaucoma, an easily treated disease, because her overloaded schedule made eye exams seem like a luxury.

Trading, the other side of the business, is stereotyped as the antipode of investment banking, with the market makers and the dealmakers viewing each other in disdain. While there are other subcultures within large firms, the bankers and the traders are the alphas and set the tone.

In the old days, traders were almost without exception order flow traders who served the socially useful function of making markets in instruments that weren’t listed on exchanges. It’s an adrenaline-filled game, with quick highs and gut-wrenching lows. Unlike bankers, who can never truly take personal credit for the profits on a deal (even if they brought it in, the firm’s franchise usually played a role), traders see their P&L as their own output, even though they use the firm’s infrastructure, research and capital.

Historically, traders often came from modest backgrounds Indeed, some scrappy firms such as the former bond market king Salomon Brothers didn’t care if traders had two heads as long as they produced.

But as Wall Street became a bigger and more profitable, in part by eating commercial banks’ lunch, trading-related jobs became more sought after. Even Tom Wolfe took note in his 1987 novel Bonfire of the Vanities, portraying Sherman McCoy as inordinately proud of the Ivy Leaguers reporting to him.

As markets became more liquid, and more complex instruments were created, firms began creating specialist trading groups to make bets with house funds. Unlike the traditional market makers, they did not deal with customer orders but were strictly out to make money into more money. The pattern for the so-called proprietary traders was set nearly 20 years ago. Securities industry denizens were taken aback to learn that Larry Hilibrand, a member of Salomon Brothers’ bond arbitrage group, made $23 million in 1990, then an unseemly sum. But even that wasn’t enough for Hilibrand; he and his colleagues decamped to form the now infamous Long Term Capital Management, which did spectacularly well before nearly bringing down the entire financial system in 1998.

Trading is an autistic activity. Markets are impersonal. And despite the shows of bravura, there’s an ever-present undercurrent of terror. Even if things look to be working out well, they could turn swiftly into monstrous losses. And again, as LTCM illustrated, it’s all too easy for successful traders to lose that sense of fear, to start believing in their own genius and take risk recklessly.

The picture of traders, both in the media and too often in their own eyes, reveals more than a bit of a John Galt fantasy, casting them as brilliant, productive people, with others piggybacking on their earnings. That’s hogwash. Traders conveniently forget that they have managed to get themselves in a hugely advantageous position: They get a slice of their profits if they win, but don’t disgorge them when they screw up. The worst that happens is they lose their job. And a remarkable number fail upwards, or at least sideways. Witness how John Meriwether, is now raising his third fund after heading two firms (LTCM and JWM Partners) that failed.

Moreover, traders benefit from massive subsidies, such as artificially low interest rates (not just now, but certainly since 2001 and, some argue, even earlier), plus industry-serving policies that produced a highly concentrated structure, with a small number of firms sitting at the nexus of massive capital and information flows. The big Wall Street firm trader’s claim that he is an independent operator fully deserving his earnings is a wonderful bit of mythology. It’s like claiming prowess in hunting based on the results achieved at a well-stocked game reserve, with some of the prey drugged to boot.

Many psychological disorders are otherwise healthy tendencies carried too far, unchecked by other personal attributes. Single-mindedness, drive to succeed, aggressiveness and lack of remorse are useful traits in business, but when do they tip into the psychopathic? In the case of Wall Street, the collective psyche has suffered as important checks on ego and behavior have eroded.

One no longer operative constraint is the partnership form of ownership. In the days when partnerships prevailed, senior management had good reason to keep pay demands in line. The partners had most of their wealth tied up in the business; they lived poor and died rich. If the firm suffered a loss, the consequences were disruptive to catastrophic. You couldn’t replenish capital easily; mortgaging the house will only go so far. And the partners were personally liable. They were on the hook for any shortfall. Many once famous Wall Street names lost their independence due to weak performance or losses: Kuhn Loeb, First Boston (over a series of years), Bache & Company, A.G. Becker, Lehman Brothers Kuhn Loeb (in 1984), Drexel Burnham Lambert.

But despite the peril it posed to the owners, the partnership form had some compelling advantages: Compensation levels were confidential, so as not to annoy less well remunerated clients, and the firms were not exposed to double taxation. And the partnerships had a cachet that the public firms, mainly retail brokers, sorely lacked.

That mode of operation in turn produced a great deal of vigilance, at least in the firms that proved to be survivors. The management committees needed to set pay levels so that the business was also retaining sufficient capital to remain competitive. These owners also had narrow spans of control, acting as players in as well as managers of businesses they had grown up in. In the market-making businesses, they were usually the senior traders on the desks and knew the foibles of their subordinates.

And so performance-inducing levels of compensation and the long-term health of the business were held in balance. Moreover, the leadership had reason to rein in big egos, since they could feel emboldened to take risks that would jeopardize the firms.

In the early 1990s, Sallie Krawchek, then an equity analyst covering publicly owned investment banks for Sanford Bernstein, remarked, “It’s better to be an employee of a Wall Street firm than a shareholder.” Being public changed all the incentives. Management had less reason to be cautious. Indeed, that also showed up in her analysis. The most profitable business was fixed income, meaning the debt-trading business, and even then the firms were on a trajectory of taking on more risk.

And more risk changes the meaning of trader profits. The private partnerships had managed against the fact that the non-partner market-makers didn’t share in the downside, and a key device was making sure that joining the partnership was the richest reward. That alone encouraged underlings to be more judicious.

To illustrate how much values have shifted in a money-minded business, John Whitehead, the former co-chairman of Goldman who presided through 1984, blasted the current CEO Lloyd Blankfein over the “shocking” pay levels. “They’re the leaders in this outrageous increase,’’ Whitehead remarked in 2007. He urged the firm to be “courageous” enough to lower bonuses and re-instill a sense of propriety.

But Whitehead, like most seasoned hands trying to persuade younger generations of the error of their ways, was ignored.

In the “other people’s money” world, there was less reason for restraint. Indeed, an expression has become common that would have been unthinkable in the 1980s: “IBG, YBG”— “I’ll be gone, you’ll be gone.” In other words, long-term consequences (likely damage) don’t matter; all that counts is this year’s kill. And if it’s big enough, you will never need to work again.

This attitude is predatory. And it has become widespread. A former Deutsche Bank employee, Deepak Moorjani, wrote:

When speaking about the banking sector, many people mention a “subprime crisis” or a “financial crisis” as if recent write-downs and losses are caused by external events. Where some see coincidence, I see consequence. At Deutsche Bank, I consider our poor results to be a “management debacle,” a natural outcome of unfettered risk-taking, poor incentive structures and the lack of a system of checks and balances.

In my opinion, we took too much risk, failed to manage this risk and broke too many laws and regulations. … [T]he system of incentives encourages people to take risks. I have seen honest, high-integrity people lose themselves in this cowboy culture, because more risk-taking generally means better pay. Bizarrely, this risk comes with virtually no liability, and this system of O.P.M. (Other People’s Money) insures that the firm absorbs any losses from bad trades.

And remember, in the Brave New World of OPM, management has every reason to be in on the game. Their bonuses are a function of the profitability of the businesses that report to them. And now that the consequences are evident, it is easy to rationalize the behavior: Everyone else was operating the same way, there was money to be made, you were just providing what the “market” wanted.

A second change has been in how members of the industry see themselves. Most I ran across were proud to be members of respected firms (the reaction when offering your card was quick confirmation), but no one labored under the delusion that finance was an elevated calling. It was a necessary function, the plumbing of a capitalist economy. If there was anything to congratulate yourself for, it was having discovered and gotten into a field that offered outsized rewards, thanks to regulatory and scale-based barriers to entry. The same M&A banker who jeopardized her health in her successful pursuit of partnership once commented dismissively, “It’s indoor work.” A successful institutional salesman said he had never run into more mediocre overpaid people than on Wall Street.

Thirty years of conservative extolling of the virtues of “free markets” seems to have contributed to the banking sector’s inflated ego. Even though the securities markets are far from “free” (they are regulated to varying degrees), the mythology has taken hold that players in finance allocate capital to its best uses—a role of vital importance to society—and therefore deserve to be more richly compensated than everyone else. Such rationales became necessary as growth in capital markets pay greatly outstripped that of other forms of indoor work.

But this flattering self-image is inaccurate. It’s the end investors that are making the capital allocation decisions; the brokers and bankers are facilitators and an information hub. And, unfortunately, as we’ve seen with auction rate securities and dodgy collateralized debt obligations sold to hapless investors as far away as Norway and Australia, the sellers were sometimes less than forthcoming about the quality of the wares they were peddling.

Nevertheless, one sees bankers and brokers, who concede that much of the anger directed at fancy finance is “very well deserved” nevertheless take DeSantis-like exception to their specialty being spattered in the mud-slinging. From the blogger Epicurean DealMaker:

And, in twenty years of offering M&A and financial advice to corporate clients, I have yet to meet someone who has intentionally pushed a “bad” M&A idea to a client, either. Sure, I’ve been in pitches where a banker has proposed silly, ill-thought-out, or downright stupid M&A ideas to a client, but those instances are either unintentional—in which case the client throws the banker out of his office and said banker usually gets fired in the next round of layoffs—or intentionally designed to provoke a deeper and more productive dialogue with the client.

One wonders, has the Epicure ever actually worked on the sell side? There, the banker’s role is to elicit the best possible price. And, trust me, plenty of crappy businesses get peddled. That’s precisely when a broker adds most value, in monetizing a garbage barge, and I saw tons of them when representing one of the preferred dumping grounds, the hapless Japanese. Ah, but of course! They aren’t your client; it’s perfectly OK if the guy on the other side of the table is a stuffee.

Yet to prove his point that the critics have gone overboard, the Epicure wraps himself and his colleagues in a mantle of “we’re good guys in our sector.” What is troubling is that his black-and-white portrait doesn’t appear to be a rhetorical device; he seems to believe it.

Later he writes:

Would the esteemed economist from the New York Times care to explain to me exactly how the finance industry was able to unilaterally increase demand for its services while drastically expanding its operating margins? Maybe I don’t remember my entry-level Economics so good, but that strikes me as a somewhat dubious proposition. And yet, that is exactly the conclusion an inattentive or ill-informed reader would draw from Mr. Krugman’s tendentious screed: regulate those nasty bankers, before they force our country to lever up and make them filthy rich again!

The anger is as telling as the logic, or lack thereof. The Epicure never addresses the inconvenient truth that lay at the heart of all those arguments for stricter regulation: that the rising asset values that fueled the securities industry boom in turn were the result of ever-increasing borrowings. Private sector debt to GDP rose gradually in the 1980s, more steeply in the 1990s, and went near hyperbolic from 1999 onward.

In modern economies, we don’t let banking systems that lend money on a reckless scale go bust, as much as that would be a useful cautionary practice. We socialize the losses. Those who weren’t perps fail to acknowledge that they benefited from the wanton risk-taking nevertheless. In the case of the Epicurean Dealmaker, how can he not recognize that transaction prices were pushed up enormously by the easy access to cheap deal funding? And that his fees, set as a percentage of the deal price, were higher as a result? Many of the cheap loans that funded transactions and pushed M&A prices into the stratosphere were in collateralized loan obligations. The big lenders and investment banks hadn’t unloaded them when the crisis hit, so they are part of the losses that taxpayers are now eating.

That’s why the great unwashed public is furious. They may lack the sophistication to grasp the arcana of the financial crisis, but they sense that the explanations for the costs they are bearing are insufficient; they see that a lot more people were feeding at the trough, directly or indirectly, than the poster children served up for public ridicule. And they’re right.

So the whining, the petulance, the defensiveness, the distorted reasoning, signifies something much deeper and more troubling.

Finance has lost sight of its role.

Banking and capital markets have become important to advanced economies, but also they represent a charge on the productive economy, just like lawyers and national defense. Ironically, the Japanese understood this well, and were still unable to prevent a turbo charged borrowing binge that left their economy a mess. They recognized that letting banks be very profitable comes at the expense of industry. And indeed, until the global financial crisis, while Japan’s domestic economy remained mired in deflation, its export sector was still robust. When our crisis broke out, Japanese policy makers were uncharacteristically blunt and warned the US that the mistake they had made was not cleaning up their banking sector quickly. We are repeating their error for the very same reason: financial firms have great political clout.

Or, as John Maynard Keynes put it, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done.”

Yet the people at the heart of this system, even with the wreckage they created all around them, still fail to acknowledge that the rich pay of recent years was the product of a debt binge. It wasn’t just the makers of the pernicious securities who benefited; all boats in the finance industry rose with the surge of borrowing. Trying to defend the status quo ante shows a willful, self-serving blindness to the proper place of financial markets in a healthy economy.

Worse, it bespeaks a dangerous, destructive ideology that has somehow managed to live on, zombie-like, through the crisis. The idea that the needs of the financial sector trump those of the productive sector isn’t just specious; as the crisis so vividly demonstrated, it’s outright dangerous. But its strange persistence as an article of faith among our leadership class, both in government and the media, has yielded inertia and fecklessness where there should be energy and resolve. It seems that before we can confront the challenge of mending our broken financial system, a battle of ideology must be waged and won. And the hour is getting late.

Enjoy!

View the segment here.

By Washington.

As I wrote last August:

Commonly-accepted wisdom says that we can inflate our way out of our debt crisis.

***

But as I have previously noted, UBS economist Paul Donovan has demonstrated that governments can’t inflate their way out of debt traps, saying:

The problem with the idea of governments inflating their way out of a debt burden is that it does not work. Absent episodes of hyper-inflation, it is a strategy that has never worked.

Megan McArdle points out:

It is a commonplace on the right that we’re going to have enormous inflation, not because Ben Bernanke will make an error in the timing of withdrawing liquidity, but because the government is going to try to print its way out of all this debt.

Joe Weisenthal notes that it doesn’t quite work this way:

As this chart shows, instances of declining debt-to-GDP rarely coincide with periods of inflation. If it did If it did, we’d see more dots in the lower right-hand quadrant.

The bad news for central bankers is that creating currency isn’t like, say, diluting shareholders in a company. You’re always rolling your debt, and the market’s response to an inflationary strategy is (not surprisingly) higher interest rates. It’s a treadmill, and it’s extremely hard to get ahead.

Financial Week notes:

Analysis shows even a sizable hike in CPI won’t do much for companies or households that owe money.

Analysis released by Leverage World, a publication of debt research firm Garman Research, showed that companies that have issued debt at a coupon rate of 8%, as is typical for non-investment grade issuers, would have to see inflation hit 23% to inflate away the amount of debt they owe in 5.5 years. That’s the average amount of time that investors would have to hold such debt to compensate for the risk of default.

But investors would refuse to do so under such a scenario, Chris Garman, principal in the research firm, noted—not with yields on such debt currently running at 18%.

As Mr. Garman put it in the publication, inflation at that level “would crush the appeal of an 8% coupon.”

And while issuers would have to roll over their debt, they would find it impossible to do so. As he put it in an interview with Financial Week, “They’re staring down the barrel of an 18% coupon.”

Investment grade companies are in better shape. The same can’t be said for other public—or government—borrowers. Indeed, overall debt levels for the private and public sectors now run at roughly 3.5 times nominal GDP. That compares with 1.5 times from 1945 to 1980 and in the early 1920s.

To return to that level, Mr. Garman estimated that inflation would have to rise to around 12% or GDP increase by 75% over the next five years. Either scenario, he said, is hardly likely to materialize.

At a more realistic level of 3% real GDP growth and 2% inflation, Mr. Garman said, it would take 15 years before the overall U.S. debt level fell back under 1.7 times nominal GDP.

“There has been some talk of a rise in inflation as a panacea for distress and default,” he wrote in his report.

His analysis shows that such expectations vastly underestimate what’s required.

Prominent economist Michael Hudson wrote in February:

The United States cannot “inflate its way out of debt,” because this would collapse the dollar and end its dreams of global empire by forcing foreign countries to go their own way. There is too little manufacturing to make the economy more “competitive,” given its high housing costs, transportation, debt and tax overhead. The economy has hit a debt wall and is falling into Negative Equity, where it may remain for as far as the eye can see until there is a debt write-down…

The Obama-Geithner plan to restart the Bubble Economy’s debt growth so as to inflate asset prices by enough to pay off the debt overhang out of new “capital gains” cannot possibly work. But that is the only trick these ponies know…

The global economy is falling into depression, and cannot recover until debts are written down.Instead of taking steps to do this, the government is doing just the opposite. It is proposing to take bad debts onto the public-sector balance sheet, printing new Treasury bonds to give the banks – bonds whose interest charges will have to be paid by taxing labor and industry…

The economy may be dead by the time saner economic understanding penetrates the public consciousness.

In the mean time, bad private-sector debt will be shifted onto the government’s balance sheet. Interest and amortization currently owed to the banks will be replaced by obligations to the U.S. Treasury. It is paying off the gamblers and billionaires by supporting the value of bank loans, investments and derivative gambles, leaving the Treasury in debt. Taxes will be levied to make up the bad debts with which the government now is stuck. The “real” economy will pay Wall Street – and will be paying for decades.

Wolfgang Münchau writes:

What I hear more and more, both from bankers and from economists, is that the only way to end our financial crisis is through inflation. Their argument is that high inflation would reduce the real level of debt, allowing indebted households and banks to deleverage faster and with less pain…

The advocates of such a strategy are not marginal and cranky academics. They include some of the most influential US economists…

The best outcome would be a simple double-dip recession. A two-year period of moderately high inflation might reduce the real value of debt by some 10 per cent. But there is also a downside. The benefit would be reduced, or possibly eliminated, by higher interest rates payable on loans, higher default rates and a further increase in bad debts. I would be very surprised if the balance of those factors were positive.

In any case, this is not the most likely scenario. A policy to raise inflation could, if successful, trigger serious problems in the bond markets. Inflation is a transfer of wealth from creditors to debtors – essentially from China to the US. A rise in US inflation could easily lead to a pull-out of global investors from US bond markets. This would almost certainly trigger a crash in the dollar’s real effective exchange rate, which in turn would add further inflationary pressure…

The central bank would eventually have to raise nominal rates aggressively to bring back stability. It would end up with the very opposite of what the advocates of a high inflation policy hope for. Real interest rates would not be significantly negative, but extremely positive…

Stimulating inflation is another dirty, quick-fix strategy, like so many of the bank rescue packages currently in operation … it would solve no problems and create new ones.

And Mike “Mish” Shedlock argues:

Inflationists make two mistakes when it comes to government debt. The first is in assuming government debt is more important than consumer debt. (It will be after consumer debt is defaulted away, but it’s not right now.) The second is that it’s not so easy to inflate government debt away either…

Inflationists act as if unfunded liability costs and interest on the national debt stay constant. Also ignored is the loss of jobs and rising defaults that will occur while this “inflating away” takes place. Tax receipts will not rise enough to cover rising interest given a state of rampant overcapacity and global wage arbitrage.

Yet in spite of these obvious difficulties, the mantra is repeated day in and day out.

Inflating debt away only stands a chance in an environment where there is a sustainable ability and willingness of consumers and businesses to take on debt, asset prices rise, government spending is controlled, and interest on accumulated debt is not onerous. Those conditions are now severely lacking on every front.

CNN Money sounded a similar theme yesterday:

Some have suggested that the country could just “inflate its way” out of its fiscal ditch.
The idea: Pursue policies that boost prices and wages and erode the value of the currency.

The United States would owe the same amount of actual dollars to its creditors — but the debt becomes easier to pay off because the dollar becomes less valuable.

That’s hardly a good plan, say a bevy of debt experts and economists.

“Many countries have tried this and they’ve all failed,” said Mark Zandi, chief economist at Moody’s Economy.com.

It’s true that inflation could reduce a small portion of U.S. debt. The International Monetary Fund (IMF) estimates that in advanced economies less than a quarter of the anticipated growth in the debt-to-GDP ratio would be reduced by inflation.

But the mother lode of the country’s looming debt burden would remain and the negative effects of inflation could create a whole new set of problems.

For starters, a lot of government spending is tied to inflation. So when inflation rises, so do government obligations, said Donald Marron, a former acting director of the Congressional Budget Office (CBO), in testimony before the Senate Budget Committee.

“[W]e have an enormous number of spending programs, Social Security being the most obvious, that are indexed. If inflation goes up, there’s a one-for-one increase in our spending. And that’s also true in many of the payment rates in Medicare and other programs,” he said.

Inflation would also make future U.S. debt more expensive, because inflation tends to push up interest rates. And the Treasury will have to refinance $5 trillion worth of short-term debt between now and 2015.

“[The debt's] value could go down for a couple of years because of surprise inflation. But then … the market’s going to charge you a premium interest rate and say ‘you fooled us once but this time we’re going to charge you a much higher rate on your three-year bonds,’” Marron said.

The Treasury is increasing the average term of its debt issuance so it can lock in rates for a longer time and reduce the risk of a sudden spike in borrowing costs. But moving that average higher won’t happen overnight. And, in any case, short-term debt will always be part of the mix.

Another potential concern: Treasury inflation-protected securities (TIPS), which have maturities of 5, 10 and 20 years. They make up less than 10% of U.S. debt outstanding currently, but the Government Accountability Office has recommended Treasury offer more TIPS as part of its strategy to lengthen the average maturity on U.S. debt.

The higher inflation goes, of course, the more the Treasury will owe on its TIPS.

Just last week, the CBO noted that interest paid on U.S. debt had risen 39% during the first five months of this fiscal year relative to the same period a year ago. “That increase is largely a result of adjustments for inflation to indexed securities, which were negative early last year,” according to the agency’s monthly budget review.

What’s more, the knock-on effects of inflation are not pretty. A recent report from the IMF outlined some of them: reduced economic growth, increased social and political stress and added strain on the poor — whose incomes aren’t likely to keep pace with the increase in food prices and other basics. That, in turn, could increase pressure on the government to provide aid — aid which would need to keep pace with inflation.

If We Can’t Inflate Our Way Out of the Problem, What CAN We Do?

So if we can’t inflate our way out of this mess, what should we do?

The above-quoted CNN article says:

So where does that leave lawmakers? Facing tough choices.

Deficit hawks and market experts have been calling on lawmakers to come up with a strategy to stabilize the growth in U.S. debt, which would be implemented only after the economy recovers more fully.

The idea is to signal to the markets that the country is serious about getting its longer term debt under control so that the burden of paying it back doesn’t consume an ever-increasing share of the federal budget.

The recommended exit strategies are pretty basic, if unpopular: tax increases and spending cuts.

But why raise taxes and cut essential services when we can stop unnecessary wars and unnecessary interest costs instead?

As I recently pointed out:

Why aren’t our government “leaders” talking about slashing the military-industrial complex, which is ruining our economy with unnecessary imperial adventures?

And why aren’t any of our leaders talking about stopping the permanent bailouts for the financial giants who got us into this mess? And see this.

And why aren’t they taking away the power to create credit from the private banking giants – which is costing our economy trillions of dollars (and is leading to a decrease in loans to the little guy) – and give it back to the states?

If we did these things, we wouldn’t have to raise taxes or cut core services to the American people.

Stopping all wars which are not absolutely essential for the protection of the United States from massive and imminent attack is crucial.

And abolishing the central bank (or putting it within the Treasury department) and taking over the money and credit creation functions from the private banks may be an important part of the solution to our debt trap. See this, this, this, this, this and this.

Giant meat-eating plants prefer to eat tree shrew poo BBC

Your Chilean Sea Bass Dinner Deprives Killer Whales Wired

Mutated genetic supertrout developed in lab The Register (hat tip reader John M)

Fighting Deficit Hawks Squeezeplay. Our Marshall Auerback, a designated “troublemaker”, on tap.

The Price of Admission Columbia Journalism Review

If Democrats ignore health-care polls, midterms will be costly Patrick Caddell and Douglas Schoen, Washington Post

AIG Said to Query Bonus Holdouts on Pay in Push for Concessions Bloomberg

Rapid Rise in Seed Prices Draws U.S. Scrutiny New York Times.

The Washington Post Is STILL Missing the Housing Bubble Dean Baker

On Asymmetry, Reflexivity and Sovereign Default Rajiv Sethi

Financial Establishment Disinformation Campaign Reaches Yahoo DoctoRx

Caterpillar Joins ‘Onshoring’ Trend Wall Street Journal

Webb, Sanders Pressure Obama On Fed Huffington Post

Yves Smith for Dummies Outside the Cardboard Box (hat tip reader KM). Today’s must read .

Actually, “must reads” are supposed to be serious, so this is more fitting, and compelling too:

Calling All Rebels Chris Hedges (hat tip reader Frank A)

Antidote du jour:

A very talented movie/commerical/trailer editor, who for some bizarre reason insists on going nameless (but if you want his coordinates, don’t hesitate to ping me) assisted by Ben Fisher in a major role (finding images and video clips) and Richard Smith in a minor role (extensive sanity checking) put this together.

This may inspire McLuhan-esque debates, since I wanted something true to the medium, as in visceral and immediate, rather than the usual talking head sort of piece.

Enjoy! Oh, and turn the sound up!

If you want to download an HD version (even more gorgeous), go here. If you don’t find the download process obvious, check here for help.

For some reason, the video does not show up when you search at YouTube, which is weird, I’ve asked people who understand YouTube tell me what to do to remedy that. But the video can also be viewed at http://www.youtube.com/watch?v=pIQFPkH3ILI

Update: If you want to help (aside from buying the book, of course), forward the YouTube link (as opposed to URL for this post) to friends and family and play it again yourself there.

By Tim Duncan, Chairman of American Business Leaders for Financial Reform

Financial regulatory reform was starting to feel a lot like a political version of the movie Groundhog Day. Like Bill Murray’s character in the movie – forced inexplicably to live the same day over and over until he learned from his mistakes – the Democrats on the Senate Banking Committee have been “days away” from reaching an agreement for a bi-partisan bill with Republicans for almost three months now. Finally, it appears that the calendar will also move forward on financial reform assuming Senator Chris Dodd’s announcement today that he would introduce a bill on Monday and have a Committee vote within a week proves to be accurate.

As with health care, financial regulatory reform has been a gold mine for the lobbyists, power brokers and political fund-raisers in Washington who profit from the debates and disputes that hound our country and who are forced to look for new business when decision and resolution allow us to move forward.

But unlike the health care debate, over 80% of the American people agree that Congress needs to act now to fix what is broken in our financial system. Polls show that the vast majority of Democratic, Independents and Republican voters agree that legislation is needed to protect consumers and taxpayers from another financial crisis. The polls also show that Americans are fed up with the financial services industry’s brazen attempts to stop reform and the political cow-towing to industry lobbyists.

The debate over financial reform has gone on for over a year – we are not acting hastily. At the behest of the financial services industry, proposed legislation has been scaled back again and again – particularly with regard to consumer protection. For every concession that has been made (the elimination of uniform product requirements, exempting community banks etc.) industry lobbyists have come up with two or three new objections and moved the goal posts back another 25 yards. We have reached a point where the industry’s objections to moving down the path to sensible financial reform would be almost laughable if the potential consequences were not so serious.

For example, the latest industry argument against the Consumer Financial Protection Agency is that protecting American consumers must be subservient to the safety and soundness of financial services companies. This is one of those arguments coming out of Washington over the last few years that are hard to respond to because they are so completely groundless (think death panels). It’s like trying to debate someone who claims that elephants grow on trees.

We have numerous agencies in government who look out for the safety and well-being of Americans. The Federal Aviation Administration is charged with making sure that we fly safely and not with insuring that airlines make money. The US Food and Drug Administration tries to prevent the distribution of dangerous drugs without considering how profitable deadly drugs might be to a pharmaceutical company. Would we want the National Highway and Safety Administration telling Toyota they were off the hook because sticking accelerators helped to insure the profits of the auto industry?

What makes the financial services lobbyists’ arguments even more preposterous is that until recently they were the ones claiming that government agencies charged with regulating the safety and soundness of banks had no business or right to try and implement consumer protection. For example, in 2006 when the Federal Reserve and the FDIC began to try and reign in non-standard mortgages, the banking industry went into full attack mode. But the industry argument then was that safety and soundness must be strictly walled-off from consumer financial protection. A letter to the FDIC from the American Banking Association in March of 2006, for example, carried on for pages about the separation of safety and soundness from consumer protection with choice tidbits such as this:

The American Banking Association is concerned that these apparent changes in supervisory and enforcement policy may arise simply from trying to marry safety and soundness supervision with consumer protection supervision. The result of this marriage of inconvenience between supervision and consumer protection appears to blur long-established jurisdictional lines.

This letter was signed by Paul Smith, Senior Counsel to the American Banking Association who we can assume knows something about banking and regulatory law.

Members of Congress and lobbyists fighting against an agency to protect consumers argue that the agency would be staffed by unrestrained zealots who would be hell-bent on bringing the financial services industry to its knees. Hardly. If we have learned anything over the past few years it is that we have the opposite problem – staff members at agencies who are prone to capture by the industries they are supposed to regulate. This can occur for contemptible reasons – bribes, lucrative job offers etc. – but more often than not its simply because of more frequent contact and interactions with industry than with consumers.

In addition, anyone with a cursory understanding of administrative law is aware that no governmental regulatory agency is free to proceed will-nilly in issuing rules, no matter how apparently sensible, without first considering the costs and benefits of the same. The legislation for creating the Consumer Financial Protection Agency has and will have an explicit provision requiring the agency to weight the costs to industry and the impacts on safety and soundness of any rule it proposes.

The federal Administrative Procedures Act (APA) will apply to the Consumer Financial Protection Agency as it applies to other federal agencies. The APA permits agencies to issue rules only after consideration of information and data presented by interested parties. An affected party can challenge a rule, and courts can set a rule aside if the agency’s action was “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law,” or “in excess of statutory jurisdiction, authority, or limitations, or short of statutory right;” or “without observance of procedure required by law. The letter of the law and Court decisions over the years have made these provisions extremely demanding.

Yes . . .yes, I know. It’s so complicated when you actually have to read laws and take time to understand a complicated issue thoroughly. But the vast majority of the American people get it – we need to act to protect consumers and the country from the kind of abuses that caused the financial crisis.

Quite a few observers, including this blogger, have been stunned and frustrated at the refusal to investigate what was almost certain accounting fraud at Lehman. Despite the bankruptcy administrator’s effort to blame the gaping hole in Lehman’s balance sheet on its disorderly collapse, the idea that the firm, which was by its own accounts solvent, would suddenly spring a roughly $130+ billion hole in its $660 balance sheet, is simply implausible on its face. Indeed, it was such common knowledge in the Lehman flailing about period that Lehman’s accounts were sus that Hank Paulson’s recent book mentions repeatedly that Lehman’s valuations were phony as if it were no big deal.

Well, it is folks, as a newly-released examiner’s report by Anton Valukas in connection with the Lehman bankruptcy makes clear. The unraveling isn’t merely implicating Fuld and his recent succession of CFOs, or its accounting firm, Ernst & Young, as might be expected. It also emerges that the NY Fed, and thus Timothy Geithner, were at a minimum massively derelict in the performance of their duties, and may well be culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations.

We need to demand an immediate release of the e-mails, phone records, and meeting notes from the NY Fed and key Lehman principals regarding the NY Fed’s review of Lehman’s solvency. If, as things appear now, Lehman was allowed by the Fed’s inaction to remain in business, when the Fed should have insisted on a wind-down (and the failed Barclay’s said this was not infeasible: even an orderly bankruptcy would have been preferrable, as Harvey Miller, who handled the Lehman BK filing has made clear; a good bank/bad bank structure, with a Fed backstop of the bad bank, would have been an option if the Fed’s justification for inaction was systemic risk), the NY Fed at a minimum helped perpetuate a fraud on investors and counterparties.

This pattern further suggests the Fed, which by its charter is tasked to promote the safety and soundness of the banking system, instead, via its collusion with Lehman management, operated to protect particular actors to the detriment of the public at large.

And most important, it says that the NY Fed, and likely Geithner himself, undermined, perhaps even violated, laws designed to protect investors and markets. If so, he is not fit to be Treasury secretary or hold any office related to financial supervision and should resign immediately.

I am reading the report, and will provide an update later, but here are the key bits (hat tip reader John M). As much as Karl Denninger has done some terrific initial reporting, he does not go far enough as far as the wider implications are concerned.

The key revelation is that Lehman as of late 2007 was routinely using repo transactions at the end of the quarter to mask how levered it truly was:

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.2850 Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851 Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.

Yves here. The stunning bit is these “repos” were actually a conventional type of repo, despite the name, but Lehman was engaging in blatant misreporting, treating these “repos” (in which a bank still shows them on its balance sheet as sold with the obligation to repurchase) as sales. Note that at the time (as the report notes) analysts and others kept probing at the seeming miracle of Lehman’s deleveraging in a difficult market. This ruse may also square the circle on a Lehman leak we broke in 2007. A former Lehman MD had reported that most of the deleveraging that had occurred at the end of 2Q 2008 had resulted from the placement of $55 billion of assets with newly-formed entities in which Lehman retained a 45% ownership interest and were operated by former Lehman employees. To put it mildly, these were off balance sheet entities that strained the idea of independence. Bloomberg got hold of the story, and Lehman asserted that only $5 billion of assets had actually been transferred. I am now wondering whether the $55 billion were indeed transferred precisely as the source had said originally (he in turn had been told this by several people at Lehman) but that most of it was via this type of repo, and then re-materialized on Lehman’s balance sheet once the quarter end had passed (the Examiner’s report notes that the amount that Lehman moves off its balance sheet at the end of 2Q 2008 was $50.38 billion, which tallies with the difference between what the Lehman MD said had been moved off balance sheet versus what they fessed up to when asked by Bloomberg) .

Denninger raises one question: were other banks engaging in this type of accounting chicanery? But there is another question: did some of Lehman’s counterparties must have suspected what was going on, given that this took place on a large scale basis at the end of every quarter? How many had an idea that Lehman was engaging in massive window dressing and chose to play along?

But here is the part of the report that discussed how the Fed aided and abetted Lehman misconduct:

the Examiner questioned Lehman executives and other witnesses about Lehman’s financial health and reporting, a recurrent theme in their responses was that Lehman gave full and complete financial information to Government agencies, and that the Government never raised significant objections or directed that Lehman take any corrective action.

Yves here. So get this: even though Lehman dressed up its accounts for the great unwashed public, it did not try to fool the authorities. Its games playing was in full view to those charted with protecting investors and the financial system.

So what transpired? The SEC (which in all fairness, has never had much expertise in credit markets, this is a major regulatory problem) handed assessing Lehman over to the Fed, which bent over backwards to give it a clean bill of health:

After March 2008 when the SEC and FRBNY began onsite daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress‐testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank.5753 The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.”5754 Lehman failed both tests.5755 The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed.5756 However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed.5757 It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

Yves here. So get this: the stress tests were a sham. Only one outcome was permissible: that Lehman pass. So after the Fed was unable to come up with an objective-looking stress test that Lehman could satisfy, they permitted Lehman to devise a test with low enough standards to give itself a clean bill of health.

So why should we trust ANY government designed stress test, particularly when the same permissive grader, Timothy Geithner, was the moving force behind the ones dreamed up last year, which have been widely decried by banking experts, including Bill Black, Chris Whalen, and Josh Rosner? We linked to a simple analysis by Mike Konczal that demonstrates that for the biggest four banks alone, merely on their second mortgage portfolios, the stress tests of 2009 were too permissive to the tune of at least $150 billion.

Lehman type accounting, in other words, is being institutionalized, with the active support from senior government officials.

It is time for Geithner to go. He is not fit to serve as Treasury secretary.

And the time is overdue for a full audit of the Fed, and in particular the New York Fed, from the start of the Bear crisis through and including all the retrades of the AIG bailout.

Update 12:00 AM, 3/12/10. Oh, boy, the spin is in in the US. Bloomberg focuses on an interesting revelation in the report, but which strikes me as secondary, that JP Morgan and Citi delivered the fatal blow to Lehman by withholding collateral. That JP Morgan seized $17 billion of collateral has been reported elsewhere; the only new elements are Citi’s role and that its and JPM’s actions could serve as grounds for legal action:

“There are a limited number of colorable claims for avoidance actions against JPMorgan and Citibank,” Valukas said in the report. He defined a colorable claim as sufficient credible evidence to persuade a jury to award damages at trial.

The Times pointed ignores the Fed’s lapses, as does the Journal and the major report at the Huffington Post.

Update 3:00 AM. Have now read the germane section a bit (over 300 pages, please do not bust my chops). Every page is stunning (the law firm did a great job, this is one case where big fees are associated with big time value). The nonsense is mile high. Lehman had been doing this sort of thing since 2001. No US law firm would give them cover via an opinion letter for their phony repo accounting, they managed to get the opinion they sought in the UK and accordingly shuffled assets through the UK for the repo 105 transactions. Frankly, if you don’t need colorful characters or glam settings, this is as attention-capturing as Too Big To Fail

A war of words has broken out between the Treasury Department and the EU over proposed EU financial services regulations. The first salvo in this dispute occurred earlier this week, when, as reported in the Guardian, American banks were excluded from the sovereign bond market, which means new issues (they obviously cannot be prohibited from making secondary trades in an OTC market). This is seen as punishment for their role in helping various states evade EU rules on deficit spending via using currency swaps. But as the Guardian noted, the EU increasingly has broader concerns about the appropriateness of an Anglo Saxon finance model that looks predatory:

“Governments do not have the confidence that the excessive risk-taking culture of the big Wall Street banks has changed and they still cannot be trusted to put the stability of the financial system before profit,” said Arlene McCarthy, vice chair of the European parliament’s economic and monetary affairs committee. “It is no surprise therefore that governments are reluctant to do business with banks that have failed to learn the lesson of the crisis. The banks need to acknowledge the mistakes that were made and behave in an ethical way to regain the trust and confidence of governments.”

Yves here. Now despite the howls from the US (more on that shortly) this is not as unreasonable as it sounds to people conditioned to think that regulators have no business…..regulating. For instance, it standard operating procedure that when a defense contractor has violated certain rules, that it will be frozen out of the contracting process for a while, the length of exclusion depending on the seriousness of the misconduct. Similarly, foreign regulators have taken much more serious actions against US miscreants in the past (Citi was forced to shut down its private banking operations in Japan, which had a major focus of their business in that country, as a result of serious regulatory violations and resulting termination of licenses. That’s not a bug, that goes with the terrain in any regulated businesses). These firms operate with the sufferance of the state, and the state reserves the right to intervene if it does not like the behavior that results. Now there is an implicit obligation on the part of the state not to intervene capriciously, otherwise no one would take up these franchises to begin with.

The other reason this action is not as unreasonable as it is being seen in the US is that the EU operates on a principles based system, while our legal system is rules based. We have a peculiar notion here that if a business manages to weave its way through a legal thicket, or better yet, tear down rules that constrain behavior, then all is fair, no matter how fraudulent or predatory the behavior is by any common sense standard. That sort of posture does not go over very well in a principles based regime.

So now go back and re-read the excerpt above. The right response, from the EU perspective, is for the US firms to roll over and show their bellies, which means apologize in public and private, and make at least vague, better yet specific, promises not to do certain bad things again.

But Ed Harrison called correctly what the likely response would be, namely to escalate:

I would expect the U.S. bank lobby to pressure the Obama Administration into developing demarche communiqués at the State and Commerce Departments condemning this as a protectionist move. This is the type of work that State and Commerce does regularly on behalf of companies like Chiquita Brands International. The bank lobby is much more powerful. So, one should expect this to rise to an Ambassador-level talking point.

Yves here. What he did not anticipate was how quickly temperatures have risen. As this and other blogs noted, the EU is also considering restricting the reach of private equity funds, both their ability to make investments in Europe, and the ability of EU investors to put money in US funds.

The next step was Geithner issuing a letter contend that proposed EU regulations of that suggested that these proposals were discriminatory. While on paper that argument might appear sensible, it deliberately obscures a bigger reality: the way these firms operate, particularly the PE firm practice of using leverage, and the consequences of leverage (if you get it wrong, firms go bankrupt more so that if they had not borrowed, leading to unemployment) runs afoul of other government policies. This is a matter of sovereignity conflicting with an ideology that more open markets are ever and always better. You cannot have both in absolute form, and the EU is deciding to trade off one versus the other in a manner different than the US does.

Needless to say, the EU is not taking this lying down, and points out that some of the actions that Geither was taking aim at in his broadly-worded letter were in fact consistent with G-20 commitments:

A spokesman for Michel Barnier, the new EU internal market commissioner who is responsible for financial services regulation and to whom Mr Geithner addressed his concerns, said that the EU decision to act on hedge funds was in line with a G20 decision to reinforce transparency in the financial system.

He added that the new commissioner wanted to “work closely” with the US, to ensure “robust standards” in financial services.

Yves again. While this is all very entertaining, the focus on the tit-for-tat misses the elephant in the room: what the hell is Geithner doing lobbying for hedge funds and PE funds?

The Volcker rule makes clear that the US does not regard these as functions integral to the operation of a healthy financial system and deserving of backstopping. The vast majority of PE and hedge funds, in terms of their staffing, are small businesses. Since when do small businesses have the Treasury secretary going to bat for them in a major international spat (this is the lead story in the Financial Times right now, lest you have any doubt).

Follow the money. Its “change” and populist pre election branding to the contrary, Obama raised more money from the financial services industry than any previous Presidential candidate. And the procurer-in-chief, Rahm Emanuel, concentrated his impressive fund-raising efforts on hedge funds and private equity firms (see here, here, and here). They expect a handsome return on investment, and it sure looks like they are getting it.

By Washington.

82% of the American public wants tougher regulation of Wall Street.

Most top independent financial experts say that we need to break up the big banks and otherwise rein in the financial giants in order to save the economy.

But Summers, Geithner, Bernanke and Congress like things just the way they are.

Of course they do … they’re bought and paid for:

• Lobbyists from the financial industry have paid hundreds of millions to Congress and the Obama administration. They have bought virtually all of the key congress members and senators on committees overseeing finances and banking. The Congress people who receive the most money from lobbyists are the most opposed to regulation. See this, this, this, this, this, this, and this.

• Obama received more donations from Goldman Sachs and the rest of the financial industry than almost anyone else

• Summers and the rest of Obama’s economic team have made many millions – even in the first few months of being appointed, or right beforehand – from the financial industry

• Two powerful congressmen said that banks run Congress

• Two leading IMF officials, the former Vice President of the Dallas Federal Reserve, and the the head of the Federal Reserve Bank of Kansas City have all said that the United States is controlled by an oligarchy

The chairman of the Department of Economics at George Mason University (Donald J. Boudreaux) says that it is inaccurate to call politicians prostitutes. Specifically, he says that they are more correct to call them “pimps”, since they are pimping out the American people to the financial giants:

Real whores, after all, personally supply the services their customers seek. Prostitutes do not steal; their customers pay them voluntarily. And their customers pay only with money belonging to these customers.

In contrast, members of Congress routinely truck and barter with other people’s property…

Members of Congress are less like whores than they are like pimps for persons unwillingly conscripted to perform unpleasant services.

***

Politicians force taxpayers to pony it up — just as the services rendered for a pimp’s customers are rendered not by that pimp personally, but by the ladies under his charge. The pimp pockets the bulk of each payment; he’s pleased with the transaction. His customer gets serviced well in return; he’s pleased with the transaction. The only loser is the prostitute forced to share her precious assets with strangers whom she doesn’t particularly care for and who care nothing for her.Also like the ladies under pimps’ power, taxpayers who resist being exploited risk serious consequences to their persons and pocketbooks. Uncle Sam doesn’t treat kindly taxpayers who try to avoid the obligations that he assigns to them. Government is a great deal more powerful, and often nastier, than is the typical taxpayer. Practically speaking, the taxpayer has little choice but to perform as government demands.

So to call politicians “whores” is to unduly insult women who either choose or who are forced into the profession of prostitution. These women aggress against no one; like all other respectable human beings, they do their best to get by as well as they can without violating other people’s rights.

The real villains in the prostitution arena are those pimps who coerce women into satisfying the lusts of strangers. Such pimps pocket most of the gains earned by the toil and risks involuntarily imposed upon the prostitutes they control. No one thinks this arrangement is fair or justified. No one gives pimps the title of “Honorable.” Decent people don’t care what pimps think or suppose that pimps have any special insights into what is good or bad for the women under their command. Decent people don’t pretend that pimps act chiefly for the benefit of their prostitutes. Decent people believe that pimps should be in prison.

Yet Americans continue to imagine that the typical representative or senator is an upstanding citizen, a human being worthy of being feted and listened to as if he or she possesses some unusually high moral or intellectual stature.

It’s closer to the truth to see politicians as pimps who force ordinary men and women to pony up freedoms and assets for the benefit of clients we call “special-interest groups.”