What is the Occupy Finance book?

The content of the book is now available online here and (and the missing page) here. The cover looks like this:

occupy_finance

OCCUPY FINANCE!

Dedication to Peter Reich

Introduction: Fighting Our Way Out of the Financial Maze

Section 1. The Real Life Impact of Financialization on the 99%

Chapter 1. Heads They Win, Tails We Lose

(a discussion of the various ways the members of the 99% have become financial products)

Chapter 2. The Bailout: It Didn’t Work, It’s Still Going On, and It’s Making Things Worse

(a discussion of the purposes, magnitude, and continuing unfolding of the Bailout)

Section 2. How We Got Here

Chapter 3. How Banks Create Money … and Keep It

(a discussion of the basic mechanics of our financial system, and how they are failing)

Insert: What is Securitization?

Chapter 4. A Little History to Explain a Lot of Tragedy

(a short history of the principal legislative failures that caused the crisis and make another one likely)

Chapter 5. The Dirty Dozen Legal Outrages

(a list of twelve notable Wall Street-friendly laws or failures to enforce the ones that at least sounded good)

Insert: CDO’s, CDS’s, and Magnetar Capital

Chapter 6. New Civics: Feasting on the Commons

(an account of how ascendant finance changes government by taking its money, turning it private, buying its leaders, and keeping itself above the debate)

Section 3. Things to Do

Chapter 7. Old Bankers’ Tales… and Why to Reject Them

(a discussion of some common financial myths we need to reject, and also tell our friends to)

Chapter 8. Starting to Re-Build What’s Ours

(some proposals for better principles and strategies to develop financial rules)

Chapter 9. Resources: Thinking Outside the Corporations

(a survey of new projects, organizations, and apps that might help us find our way out)

Chapter 10. And Now…

(we conclude)

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Dedication

“If you have an apple and I have an apple and we exchange these apples then you and I will still each have one apple. But if you have an idea and I have an idea and we exchange these ideas, then each of us will have two ideas.”

George Bernard Shaw

In memory of Peter Reich, 1931-2013.

He shared ideas with us about the book, and we deeply
miss sharing the result with him.

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Insert: CDO’s, CDS’s, and Magnetar Capital

Manipulating internal risk models

The way people make money in finance is by taking intelligent risks. You get your “edge” through knowing that things are mispriced, and betting on that knowledge.

Of course, every bet involves risks, and not all bets will be correct, and you will sometimes get burned, but over time the wins will hopefully exceed the losses, and what really matters is that, relative to the risk you take on, your profits are good. That is in fact how traders are measured and how bonuses are awarded, so there’s a lot on the line.

Instead of understanding each bet individually, a bank or hedge fund generally speaking tries to keep track of only the risk each of their trading groups is taking on as a whole. Each group is required to have a risk model, which measures their risks in various ways, and is given a “risk limit” which they are expected not to exceed and which they divvy up among individual traders inside the group.

It’s a way to keep things reasonably safe for the firm. But of course, since there’s such a strong connection between risk and reward, the individuals inside each trading group would always want their risk limits, and the group’s risk limit, to be higher rather than lower.

Leading up to the financial crisis, there was a pretty well-known (and widely-used) method of working around the pesky requirements of having a risk model and paying attention to risk limits in one’s group.

Namely, the group would let a risk guy in the group for a while, long enough to write a half-decent risk model, and then would say thanks, and we don’t need you anymore, we’ll run with this, and then the guy would be kicked out of the group. The group would then spend the next few years learning how to “game”, or manipulate, the risk model.

In particular, as a trader in that asset class, one would know exactly what kind of trades one could put in that the risk model can’t “see”, in other words what isn’t accounted for by the risk model. This includes things like interest rate risk (important to understand when some financial entity all of a sudden seems less stable and more prone to defaulting on their loans) or counter-party risk (again, important to understand in case of default), that the poor risk guy didn’t think of at the time.

Even better, and common at the time, the market one traded in would have developed and changed in the last few years so the risk model was being applied to instruments it wasn’t even meant to measure.

The game went like this: it was important to always stay within the preset risk limits, as a group, even while the group took larger and larger bets on things that were invisible to the risk model. As long as the world didn’t blow up, this method returned higher-than-expected profits, so the group’s profit versus its stated (but not actual) risk looked great.

Members of the group would get rewarded for this, and in the meantime the company they worked for took on the risk, and the company typically didn’t see it as coming from any specific trading group but rather as some amorphous systemic risk.

It’s not clear how many people how high up were in on this method, but it seemed pretty clear that they also enjoyed the ride as long as it lasted. As Chuck Prince said in July 2007, as things were starting to fall apart, When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” i

The Collateralized Debt Obligation (CDO) market

One really enormous and tragic example of how people can game the risk model is described in Yves Smiths brilliant book Econnedii, in the chapter describing the CDOmarket and Magnetar Capitals involvement. It’s arguable that CDOs were the reason we had a global economic crisis and not just a housing bubble, so it’s important to understand them at least at a basic level.

What even are CDO’s? The CDO market is complicated, and you can learn a lot about it by reading Smith’s book. Here’s a very simplified version.

At the beginning, so in the late 1980s through mid-late 1990s, there were not that many securitizations outside of the federal arena (Freddie Mac, Fannie Mae, and FHA), and they were pretty useful because they made piles of riskier but still viable-looking mortgages more predictable than individual mortgages.

Recall from the previous insert entitled What is Securitization? that after being created, securities were separated in to groups called “tranches” depending on possible defaulting actions. Back in the 1980s, the pieces at the top of the securitization pile were rated AAA by the big three ratings agencies (Moody’s, Fitch, and S&P), because they had a big cushion of loss protection beneath them. The lower tranches were lower rated and harder to sell, which limited the size of the overall market.

Starting around 2003 the lower-rated, harder-to-sell tranches from the BBB to the junior AAA tranche started getting re-securitized into new instruments, which were called Collateralized Debt Obligations, otherwise known as CDOs.

So just as the mortgage-backed securities took questionable mortgages and made them into securities that people were willing to buy, CDO’s were the next step: they took the very worst mortgage-backed securities and reprocessed them into new securities that people were convinced to buy.

In fact there were riskier CDOs, called mezzanine CDOs, which consisted mainly of the BBB tranches, and “high grade” CDOs consisting mostly of old A and AA tranches. These mezzanine CDOs were again securitized, with around 75% of them getting an AAA rating.

Yes, you read that right: if you took a bunch of easy-to-imagine-they’d-fail low rated mortgage bond tranches – especially if you knew anything about the terms of those mortgages and how much they were counting on the housing market to continue its climb – and bundled them together, then most of the resulting package would be deemed AAA. The riskiest securities received the highest rating.

It made no sense then and it makes no sense now.

The CDS market

Enter the credit default swap (CDS) market.

First, what is a CDS? People have correctly described it as an insurance contract on a bond. So, for some quarterly fee, you are protecting the value of a bond.

Say, for example, that you own a 5-year bond issued by a large company like Sears. Then you might be worried about the possibility of Sears having financial problems and defaulting on this bond. If you buy a 5-year CDS to protect your bond, then in the case that Sears does default, you’ll get back your lost money from whomever wrote the CDS – as long as that insuring entity hasn’t gone bankrupt itself.

But the amazing thing is that, unlike normal house insurance, you don’t actually need to own the Sears bond (the “underlying bond”) to buy CDS protection on it. In other words, you can buy insurance on a bond you don’t own. This is more or less like betting that Sears will go bankrupt, or at least default on its bond, since you’re willing to pay a quarterly fee for the chance to make a bunch of money in the case of default.

Also, it wasn’t just bonds you could buy CDS’s for. It was also possible, and common, to buy CDS’s to protect the tranches of securitized products, like mortgage-backed securities or CDO’s.

Remember how we have talked about how risky these investments were, standing by themselves? Well now, a product had been invented to remove the risk from these financial time bombs.

So, how did people use CDS’s in their bets surrounding the mortgage market?

People bought CDS protection on a higher, less risky tranche of the mortgage bonds while purchasing a lower tranche of that same security. This meant that people were betting that “if things go bad, they will go really bad”, while limiting their overall exposure.

In other words, if the lower tranche went bad at the same time as the higher tranche, then they got back the money from the higher tranche while they lost money on the lower tranche, so things evened out. The only situation where they lost money is when the lower tranche went into default but the higher tranche didn’t, which they thought unlikely. Remember, all those tranches were made from super shaky mortgages, so there’s no reason to think some of them would go bad but most of them wouldn’t – they’d probably all go down together.

Moreover, the income on the lower rated tranche, i.e. the money coming from those risky mortgages, would be sufficient to pay for the CDS fees on the higher rated tranche. In finance this is called a “self-financing bet,” and in particular it meant that people could do it a whole lot. Which they did.

The synthetic CDO market

Recall that a CDO is a re-securitized security. The money paid out from a mortgage-backed CDO comes from a mortgage somewhere, even though it takes a few twists and turns to get there.

But what if the demand for CDO’s outstrips the supply? In the mid 2000′s, investors became hungry for ever more bets on the mortgage market. In fact there was more demand than could be sustained by the large but finite mortgage market at the time.

The demand for more CDO’s (and for more CDS’s to play the game described above) led some clever traders to realize they could create CDO-like instruments, which they called “synthetic CDOs,” largely or entirely from credit default swaps rather than actual bonds. The money coming from synthetic CDO’s wasn’t paid by mortgage holders, but by the traders who were paying quarterly CDS fees from other bets altogether.

Once synthetic CDO’s were invented, there was no longer any need to be constrained by finding real borrowers. Moreover, traders could bet against the same crappy BBB bonds again and again, and have them packaged up and have most of the value of the “synthetic” or “hybrid” CDO rated AAA, again with the collusive help of the ratings agencies.

The first mortgage-backed synthetic CDO was issued in 2005, and by 2006, the synthetic CDO market was bigger than the actual CDO market, at $5 trillion in assets.

Who was doing this stuff?

At first, the big protection sellers in the CDS market was insurance behemoth AIG and other insurers – which makes sense, since as we said CDS’s are like insurance. But they only wrote CDSs on the least risky AAA CDO tranches.

Later, after AIG stopped being involvednot soon enough, as we later sawthat side of the CDS market was entered into by all sorts of unsophisticated investors, with the help from the complicit ratings agencies who kept awarding AAA ratings.

Magnetar

Even so, there was still a problem for this re-re-bundled synthetic/heavily synthetic CDO market. Namely, it was hard to find people to buy the so-called “equity tranche”, which was the tranche that would disappear first, as the first crop of the underlying loans defaulted. This tranche contained mortgages that no sane person expected to pay out, which is why it was considered toxic.

That’s when hedge fund Magnetar Capital came in. They set up deals to fail. They did this through explicitly designing the synthetic CDOsbanks gave this privilege to whomever was willing to buy the equity trancheand by buying all the CDS’s in that synthetic CDO, in addition to buying the equity tranche. The CDOs that Magnetar designed to fail, were then sold by banks to pension funds and other gglobal investors. The banks selling them did not consider it relevant to tell the buyers that the deal was designed by a hedge fund that was making a huge bet on their failing.

The overall bet Magnetar Capital was taking was similar to the one above: when the market goes bad, it will go really bad. The difference is that Magnetar was betting very heavily against the mortgage market in the short term: they set up the equity tranche to pay lots of cash quickly, say within two years, which would finance the cost of all of the CDSs in the hybrid CDO. This meant they didn’t just cover the exposure but magnified it multiple times. They were leveraging their bets against the super risky mortgages.

And it was again a self-financing bet, as long as they were right about the market exploding rather than slowly degrading. In other words, for the first two years it paid for itself, and they were betting that it would be all over within two years.

How big was this? Magnetar Capital made the majority of the market in 2006, which was one of the biggest years in this market. And everything they did was legal, although the banks committed fraud when they sold the deals without mentioning who designed it and why. They also drove demand in the subprime mortgage market, during its most toxic phase, by dint of a combination of leverage and the clever manipulation of investors.

Conclusion

If this seems immensely complicated and confusing, it’s because it is and it was designed to be that way.

Let’s go back to the groups gaming their risk models from the beginning of this section. The same thing happened here, except instead of fooling the company they were working in, Magnetar was fooling the entire market. Instead of one risk guy, there was a combination of the ratings agencies and AIG, as well as the greedy fools who wrote CDS’s on mortgages in 2006.

Finally, instead of the hedge fund Magnetar being on the hook for their trading group’s games, in this case it was the United States and various European governments who were on the hook (and the investors who’d been duped into buying this stuff).

How predictable was this whole scheme? Goldman Sachs knew exactly what was happening and most likely what was going to happen. They made a very intelligent bet that if and when the housing market went under, AIG would be backed by the government.

In essence this entire market was an enormous bet on a government bailout. Not everyone knew, of course, especially the guys who were still betting on the mortgage market when it collapsed, but lots of people knew. The same people who, right now, are lobbying against reasonable financial regulation.

This story argues for, at the very least, the treatment of CDS as insurance, with the associated regulations. Any thinking human being should recognize that you need to own something to buy insurance protection on it, just like with home and fire insurance.

Put it this way. Magnetar chose buildings they didn’t own, where they saw arsonists enter with gallons of gasoline and matches, and bet everything on the probability of fires in those buildings.

iMichiyo Nakamoto in Tokyo and David Wighton, “Citigroup chief stays bullish on buy-outs”, Financial Times, July 9, 2007 http://www.ft.com/intl/cms/s/0/80e2987a-2e50-11dc-821c-0000779fd2ac.html?siteedition=intl#axzz2dfSm7o8G

iiYves Smith, “ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism”, Macmillan 2011

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Insert: What is Securitization?

Part of the difficulty ordinary citizens, even well-informed ones, have in coming to grips with what has happened within international finance is the vocabulary used to discuss money matters.  Not just you and me but elected representatives, bureaucrats, and even employees paid to oversee municipal and pension fund investments have widely varying levels of understanding of what, exactly, a particular investment consists of and how risky it is.  And adding to the complexity is the fact that very smart people–what a BBC documentary termed “The Rocket Scientists of Finance”–are creating new financial instruments and naming them all the time, sometimes with intentionally obscure names.

Securitization is one term, and process, that is so fundamental to our current system that it is worth spending time clarifying, and admittedly simplifying, what it is.  Most of us learned that a security is the name for a stock or bond, and many of us retain a basic, drawn-for-a-textbook idea of stocks and bonds.

Let’s start with the most basic financial instruments and work our way one step at a time. If you own stock in a company you own a share, a tiny little piece, of the company; you might receive a dividend if the company does well, although not all stocks provide dividends, or you might lose money if the company does poorly, in the sense that your little piece of that company would be worth less.

If you own a bond, you have given a loan to the company (or the government) and you don’t own a share but are promised a certain rate of interest for the loan.  You can sell your stock or bond, but of course that will be difficult if the company is not doing well or if a lot of other people want to sell the same security at the same time.

Similarly, if you borrow money from a bank, they own the contract you signed promising to pay back the debt. So if it’s a mortgage, you’ve agreed to pay back the loan little by little, possibly over the course of 30 years. From the bank’s perspective, this is an asset they own, which they hope will be paid back, but of course 30 years is a long time to wait, and after all you might declare bankruptcy and not pay it back. In the meantime the bank is stuck waiting around for those 30 years to go by. At least that’s how it used to work.

Securitization is a way of turning one kind of financial product into another kind of financial product; it is a repackaging of assets so that they can be sold to investors, and it was invented so banks don’t have to sit around for 30 years to see if you actually pay off your mortgage. Instead, they put together a bunch of mortgages in what they call a “pool” and they make the statistical guess as to how often people in that pool will pay off their mortgage and how regularly.

More generally, securitization happens to certain flavors of debts, which are viewed as assets as the mortgage is above..  When many debts are added together or pooled, the expected regular payments by the debtors can be looked at as a source of income for the investors.

Let’s look into the mortgage debt and securitization example some more.  An individual goes to a bank and takes out a thirty-year mortgage with specified monthly payments; a lot of other people go to banks and take out mortgages.

However, in our high-speed, pressured-to-maximize-all-possibilities society, we can intuit that the concept of mortgage repayment over fifteen or thirty years, with no extra money being made in the interim, seems incredibly stodgy and unimaginative, and the bank who owns all these mortgages is impatient.  So that bank sells a whole group of mortgages, sometimes hundreds of them, to another financial firm.  That firm divides the mortgages up into pools.  These pools are then marketed as investments, or securities; the mortgages have been securitized.

Moreover, as securities, they are divvied up relative to their risk. So, the first-to-default loans are the most risky, and the last-to-default loans are the safest. The different levels of loans, seen from this risk perspective, are called the tranches of the security, and have different credit ratings accordingly – more on this in a later section entitled “CDO’s, CDS’s, and Magnetar Capital”.

The people at the bank that originally sold the mortgages to the financial firm are pleased, because they have made money on the sale and now have none of the risk of mortgage holders not being able to pay – it’s gone from their system.

The people at the financial firm that securitized the mortgages are also pleased, because they made money selling the securities, and they also don’t have to worry about not being paid by homeowners.

The buyers of the securities are also pleased because they believe that they are assured of a regular stream of income from those mortgage holders dutifully paying off their debt each month.

The buyers – investors – for the most part have been convinced that, while a few mortgage holders might not be able to pay in a given month, it is extremely unlikely that lots of them will not pay and risk losing their homes. Unless something really crazy happens, of course.

A few things need to be pointed out about securitization.

First, no particular person or group of people feels responsible for making sure that mortgage loans that are made can be repaid in a timely manner.  The banks sells the mortgages and gets rid of them; next the financial firm packages them and gets rid of them; and the end investor knows nothing about the individual loans and is betting on how well the whole conglomeration of mortgage loans will do. As a result, mortgages were sold with little concern for whether the borrowers would be saddled with unpayable debts on depreciated properties.

Second,  the original loan can land quite far from the place of origin of the loan.  A firm in Germany may hold investments in mortgages that started out in West Virginia.

Finally, there is little access to the loan once it’s been securitized. A family with questions or difficulties with a mortgage often has great difficulty finding out who to contact about the issue.

Mortgages are not the only debts to be securitized. Credit card debt, student debt, auto loan debt – all of these debts and lots of others have also been securitized.  So one person’s debt becomes another person’s investment opportunity, which may be why our society does not encourage us to live as debt-free as possible.

The complexity increases when additional financial innovations like Credit Default Swaps (CDS) get combined with our Mortgage-backed Securities (again, see the later section “CDO’s, CDS’s, and Magnetar Capital” for more on these).

Note: we are deep in the weeds and need a trusty guide to get us out. But there is a terrible shortage of trusty guides, likewise a shortage of laws to regulate the use of various financial instruments, and, most important, an unwillingness to imagine the consequences as each individual player tries to maximize his or her money-making opportunities.

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New Civics: Feasting on the Commons

“I see in the near future a crisis approaching that unnerves me and causes me to tremble for the safety of my country. . . . corporations have been enthroned and an era of corruption in high places will follow, and the money power of the country will endeavor to prolong its reign by working upon the prejudices of the people until all wealth is aggregated in a few hands and the Republic is destroyed.”

—U.S. President Abraham Lincoln, Nov. 21, 1864
(letter to Col. William F. Elkins)

 

Before moving on to some possible responses to the host of problems the financial sector has wrought, there is one more set of related issues to address. These concern what the rise of the financial sector has done to our governments, to our sense of certain places or functions as being “public”, and to our core notions of democracy.

Predatory Public Finance

First, it should come as no surprise that with local and state governments collecting billions of dollars from various tax streams, Wall Street was not going to leave this taxpayer money alone. Some of the most outrageous stories concern what happens when local governments—the ones we rely on to provide services like road maintenance, education, and policing—have had to turn to Wall Street for capital.  Because of the Wall Street-induced recession, our municipal governments have suffered both a decline in tax receipts and an increase in social service spending.  They have been battered by years of corporate fueled anti-government campaigning and they often lack the financial sophistication necessary to win negotiations with bankers. At times, Wall Street banks have employed methods, when dealing with our towns and cities, that are only a bit – and just sometimes – more nuanced that those the 19th Century Tammany Hall gangsters who used to rob New York City. In short, the mixing of the worlds of public service and high-finance has, as you might expect, been disastrous for the 99%.

It is probably most interesting to first review some of the flat-out robberies.  Municipal bonds are a 3.7 trillion dollar industry in the U.S.  To understand how big that is, the Gross National Product for the whole country was about 15 trillion dollars in 2012.  So a smart thief should not be looking to steal a lot from every town or county bond offering.  A little should do to make him very rich.

This is what some GE Capital traders figured out, namely how to rig the bidding for municipal investments. They ultimately went on trial and were convicted for it in U.S. v. Carolla.[1] 

Here’s what happened. GE Capital was competing with the likes of Bank of America and Chase to invest the money of various municipalities that were collecting revenue from the issuance of bonds meant to support new or renovated libraries, schools, roads, and such things.  The towns did not immediately need the money coming in from the bonds, probably because whatever projects they were funding were not yet ready enough to necessitate major expenditures. So the towns retained middle-men to supposedly get “competitive” bids from financial firms to temporarily invest the money.

Remember, the towns wanted to get high interest rates on this money, because they were investing it, and so they wanted the competing firms to bid up the interest rate. Unfortunately, the GE Capital guys and their colleagues in these supposedly competitive auctions figured out that if they tipped one another off about the bids (i.e. engaged in bid-rigging), then the interest rates they ultimately needed to offer to get their hands on the municipalities’ money would come in a bit lower each time. But over ten plus years, that still really adds up even after you take into account having to grease the middle-men with some of the “savings”.

Exactly how much skimming this all added up to is either too big or too complicated to fully calculate, because we still don’t know, for sure. But some of the banks’ settlements to resolve the resulting claims have veered towards the high nine-figures, which gives you a sense of the proportions.  As you can see, it is a kind of subtle thievery. That is, you don’t have to break into any vaults, but the extra money you end up with is just as green, and it comes just as much out of the pockets of taxpayers as if it was robbed from the county safe at gunpoint.

If you prefer an example of more old fashioned skullduggery, consider, too, the tale of how JP Morgan recently milked corrupt Jefferson County Alabama administrators to such an extent that the entire county government ended up in bankruptcy.[2]

In the late 1990s, Jefferson County was required to do some infrastructure work that should have cost about $250 million, but after the work got going and construction firm pay-offs of municipal officials started flowing, the county went wild trying to build and repair more stuff.  Where better to go for funding than Wall Street? The bank of choice here was JP Morgan, and this deal got so good for it that at one point JP Morgan actually paid Goldman Sachs $3 million to stay the heck out of Jefferson County and let it continue to serve as the sole financier of this money-laundering pay-off scam extraordinaire.

It all came crashing down for the really crooked-town officials, but not so much for JP Morgan, which paid a mere $25 million fine and handed-over another $50 million to help workers displaced as a result of the County’s financial collapse.

These are not the only stories of this kind, but rather than recite one horror story after another, let’s think a little more about the less extreme examples, just to get a better sense of how widespread the problem of Wall Street’s relationship with local governments is. Let’s look at Philadelphia.

The Philadelphia school district is the eighth-largest in the country, with a $2.3 billion operating budget for 242 schools serving 150,000 children, over 80% of whom are poor.  Beginning in 2003, the district (and the city of Philadelphia itself) turned to big financial players like Wells Fargo, Morgan Stanley, Citigroup, and Goldman Sachs to try getting some certainty on their growing debt obligations.

The parties entered into a series of “interest rate swaps”, which means they basically agreed to pay one another’s debt.  Philadelphia school district agreed to pay the fixed-rate obligations the banks held, and, in exchange, the banks agreed to pay the floating-rate obligations of the schools. Philadelphia’s intent was presumably to make budgeting more predictable and possibly to save some money.  Accounts of the motivation differ, however, because things went very wrong.

As interest rates plunged after the onset of the 2008 financial crisis (and have remained at historically low levels ever since), the fixed rate payments Philadelphia owed on the debt it assumed did not fall (Philadelphia, you will recall, opted for the “certainty” of a fixed rate, rather than an adjustable rate).

Philadelphia’s tax-base and support from the State were cut because of the Recession, and the school district was in no position to keep paying interest on the swaps it was locked into way above market rates.  These total “costs” have exceed $300 million based on the combined effect of the interest rate swings and the cancellation fees the municipalities incurred to avoid having to enter into still more such swaps under the terms of the now horrible-looking original deals.[3]

While Philadelphia has recently sued many of these banks on the grounds that their manipulations of interest rates through LIBOR[4] (see chapter 5) had a lot to do with these unfortunate “swings”, you might still say that this sounds nothing like the above examples: after all, the banks did not steal this money, they just tremendously benefited from the plunge of interest rates and may have also tremendously out-negotiated the municipal parties (which happens a lot in these cases).

But, we’d argue, think for a moment about what is going on now in Philadelphia.

The banks entered into these “great” deals before 2008.  But in 2008, their other not-so-great deals (the ones related to mortgaged-back-securities) sent them into what was probably technical insolvency and almost collapsed the American economy. And that was what caused the interest rates to swing against Philly school kids: bad economies mean less demand for money and lower interest rates.

Yet in the midst of this, who gets bailed-out? In any sane society, you would say… the kids, of course. But that’s not what happened. As we know, the banks got the bail-out, funded, in part, by the tax dollars of the parents of the very same Philly school kids to whom the banks had shown no mercy.

These days governments need banks.  Bankers know it and frequently use that advantage to make deals which, in retrospect (and probably often in advance, too), demonstrate the negotiating imbalance between them. Financial transactions involving governments are often complex. A bond sale, for instance, can involve a small legion of bankers and lawyers and take several steps to execute. This offers a maze of nooks and crannies into which fees can be tucked and costs hidden.  Middlemen are often retained to arrange transactions, and, remarkably, they don’t owe the municipalities or taxpayers any fiduciary obligations in handling public monies. There are also many transactions, like the Philadelphia ones, which are intended to transfer risk (always for a fee) and risk is notoriously hard to quantify.  So even when cases are not as obviously corrupt as in the earlier examples of auction-fixing and county-official-bribing bankers, we need to press the issue and not let the questioning and analysis just end there.

Philadelphia made a bad bet, just as a large percentage of the American public did when they bought houses during the Wall Street induced real estate bubble.  But if we are going to teach our kids in Philly and other school systems about the democratic ideals of equal opportunity and civil rights, we also ought to be explaining to them the other dynamic of modern American civics, e.g. how interest rate swaps between cash-starved, financially naive municipalities and Wall Street banks are ubiquitous because they are necessary to maintain basic services, but they almost always end up unbalanced against the governmental party.

They should similarly learn that when things go terribly wrong, when massive market shifts result in real or potential collapses of basic public services like elementary school education, what this society’s civic considerations call for are not terribly consistent with the stated ideals of equal opportunity and civil rights . . . they call for the bailout of the banks.

Privatization and the Securitization of What Was Previously Public

Stealing from and getting the better of local governments is not all Wall Street is doing to undermine our civic institutions.  Under the guise of bringing us the “efficiencies” that come with “running it like a business”, an ever-increasing part of the enterprises, spaces, and services that we traditionally have thought of as “public” are being taken over by corporations.

In any individual case, this can seem benign.  For instance, the New Jersey town of Bayonne is facing a credit downgrade, so it enters into a deal with KKR’s “energy and infrastructure fund” to turn over management of its water system to the legendary private equity firm “in what bankers say may become a U.S. model.” [5]

New York City is looking to save some money on needed park-space, so it enters into an arrangement for a corporation to build a park in exchange for the City modifying the zoning rules that affect a different project the company has a stake in. The result is a privately owned “public” park (such as Zuccotti Park) made accessible to us only by virtue of the terms of the commercial agreement between its private proprietor and the City.

When these kinds of things happen, there is a problem. Something we all would otherwise hold in common, something with respect to which we would maintain rights as citizens rather than as customers, disappears. It is critical to remember that the rights we most value in our constitution are about, and only about, our relationship with a government.  In the sphere of things “private”, the “Bill of Rights” has no bearing.

Even if a shopping mall is the center of our community, we have no right by virtue of our citizenship to enter it and express our views about things like the so-called War on Terror or the Bush Tax Cuts, just as we have no right under the First Amendment to tell our boss we think he is a bigot or a lecher.

Once spaces and functions are privatized, our rights with respect to them get defined by leases, bills of sale, and other commercial agreements that turn them over to private parties—because the Constitution has precious little to say about the terms on which we serve as customers of companies performing once-public functions.

So when you hear a Congressman reading the full text of the U.S. Constitution to open a Congressional session, remember (and be careful): there is more than one way to erode the Constitution.   The hard way is to go right at it and change what it says or means, but the easier way is to pretend you love it (perhaps by reading it aloud in a public forum) but then shrink the only things to which it ever applied, e.g. our governments and the functions and spaces they provide.

Let’s assume for a moment that we don’t buy into the bull that such privatizing efforts bring wonderful “efficiencies” to formerly lackadaisically performed government services. What, we might then ask, does any of this have to do with the financial system, which is, after all, what this book is all about?  The answer is: quite a lot.

Recall the basic argument from Chapter 3 regarding the mechanics of the fractional-reserve banking system.  If the financial system is, at its core, the mechanism by which our money is made, we learned that two basic ingredients have to be present to make it work “well”.  First, banks need to lend, and then they need to have at least some of those loans get paid back with interest earned from borrowers’ successful creation of things of real value.

Second, the financial system’s securitization of some of the new enterprises—either through the issuance of shares in them or the extension of credit based on their perceived “value”—snaps “new money” into the nation’s money supply (broadly construed).  Given this, the financial system avoids the tail-chasing death spiral of having to extend new loans just to endlessly pay interest on the old ones—which, by the way, is the hallmark of a Ponzi Scheme.

But for the second part of the cycle to work (let’s call it the securitization part), it turns out that loans don’t actually need to be used to create “new” businesses.  They can just as well be made to individuals to capture, in the present, substantially all of their future earning capacity. For example, this is what happens when credit cards, student loans, or mortgages indebt us and are packaged into tradable bundles of things like mortgage backed securities, “MBSs”, and student loan asset backed securities, “SLABSs”.

In addition, loans can fund the purchase of existing public functions, which however valuable to society when they were public, were not contributing to the above-referenced money-creation cycle.

For example, the American public school system—whatever you may think about its quality relative to some foreign ones—is a thing of real value in our country.  Without it, we certainly would not have one of the world’s highest literacy rates nor would pretty much the whole population know enough basic math to “break a twenty”.

But prior to the advent of charter schools and the massive use of corporate service providers to develop and prepare kids for “achievement” tests, the public school system did not play a real role in money creation. Sure, teachers and janitors got paid for their services, but this did not create money, it was just a means by which existing money could circulate.

Once a school district, like that of Chicago or New York City, decides to let private entities run previously public schools, all of this changes.  Suddenly, the process described in “What Banks Do” regarding the 3Musketeers woodcutting operation is (sort of) at work, only instead of something really new being created from the loans, credit is being extended just so that private businesses can displace public operations.

For example, if the sort of company that administers charter schools, known as an  “Educational Management Organization” (“EMO”), takes over the back-office support for a charter school that has attracted 1,000 kids from a public one Rahm Emanual or Michael Bloomberg recently shut down as “failing”, then regardless of whether the kids get a better education at XYZ charter school, one thing is for sure:  the monetizable value of the EMO  will rise.  This is going to affect the value of some 1%er’s holdings, which means he will have more “money” available to pay interest on a loan that might be supporting a different one of his various financial ventures.

So, regardless of what is happening in the much-debated contest of educational test scores in Chicago and New York, one thing will be certain: the shift from public to private schooling will matter to the financial system and it will provide the “securitizing fodder” that is so necessary in the second part of the money-creation cycle to keep the system from too quickly reverting into pure Ponzi-like dynamics.

In other words, as far as the financial system is concerned, cannibalizing us and our existing public institutions, regardless of whether they were previously working well, is actually just as good a money-making strategy (and takes much less imagination) as funding something new that has societal value.

Given this, it should come as no surprise that the extraordinary rise we have seen in the size of the financial sector over the past 25 years has been contemporaneous with a similar rate of increase in the extent to which things we previously held in common have been privatized and securitized.  Without the plundering of our previously public enterprises, it’s safe to say that the financial system could not have experienced—nor continue to experience—its meteoric growth.

For example, while we have become accustomed to thinking of our medical system as private compared to that of Europe or Canada, as recently as the 1970s most hospitals were non-profit or public institutions. But the largest for-profit hospital company, Hospital Corporation of America (“HCA”), was only founded in 1968 (by, among others, Dr. Thomas F. Frist, the father of later U.S. Senate majority leader Bill Frist), and experienced its exponential growth in]the 1970s and 1980s as it acquiring hundreds of American hospitals, at one point owning 255 facilities and managing another 208.[6]

To give you a sense of how much freshly securitized “value” this added to the monetary base, consider that the company was re-acquired by Thomas J. Frist in 1988 for $5.3 billion and in 2006 was purchased by Kohlberg Kravis Roberts (“KKR”), Bain Capital, and Merrill Lynch for a total of $31.6 billion, all despite having been mired throughout the 90s and early 2000s in a series of criminal cases that resulted in, among other things, the company admitting to fraudulently billing Medicare and other health programs by inflating the seriousness of diagnoses and giving doctors partnerships in the business as a kickback for referring patients to HCA. Wall Street has recently been looking for the next big, previously public, enterprise to cannibalize. The push has been relentless and thus too varied to entirely capture here, but consider the following two notable ongoing examples.

K-12 Education. Sometimes we just have to thank the 1% for telling it like it is. In a 2007 article about the privatization of K-12 education, Harpers Magazine profiled Nations Bank Montgomery Securities, whose prospectus (according to the magazine’s summary) explained that:

[T]he education industry represents, in our opinion, the final frontier of a number of sectors once under public control that have either voluntarily “opened” or “been forced to open” up to private enterprise. The education industry, the bank concluded, represents the largest market opportunity since health care services were privatized during the 1970s. While college education can offer “attractive investment returns, the larger developing opportunity is in K-12.  EMOs […  are] the Big Enchilada.” [7]

Until recently, the need to maintain charter schools’ (thin) veneer of “good works” meant that most were registered as non-profits.  Almost all of them, however, are administered, in whole or in part, by these for-profit EMOs, a name Wall Street apparently coined with uncharacteristic appropriateness to (dismally) recall the Health Maintenance Organizations (HMOs) that led the 1970s charge to health care privatization based on a model of skimping on care.

EMOs are often not the public face of charter schools, but they hold contracts to do all, or substantially all, of the actual work of running a school, from leasing space, to paying teachers, to managing the operation in its entirety.  With Obama’s Secretary of Education, Arne Duncan, and the mayors of the nation’s two biggest (traditionally Democratic) cities, New York and Chicago, now solidly in the charter school camp, EMOs, and charter-schools more generally, are moving fast to exceed even the robust predictions of the 2007 Nations Bank prospectus. As of 2011, there were 5,400 charter schools in the U.S. educating about 1.7 million students, with the market growing by over 14% a year.[8]

Securitization of this new-found “value” has come slower, perhaps because the country has not been so quick to embrace the entanglement of stock-tickers and kids’ math grades.  In addition, the nation’s once leading EMO, Edison Learning (founded as “Edison Schools” by Presidents Regan’s and Bush I’s Assistant Secretary for Education), fell on its face after it went public.  At one point, it was trading at a mere 14 cents per share after the NASDAQ charged that it had over-stated its earnings by as much as 41 percent.[9]

But no worries, other forms of securitization are rapidly evolving to fill the gap. In 2011, Canyon Capital Realty Advisors—a $20 billion real estate fund which had previously partnered with Magic Johnson to fund a so called urban-improvement project in Brooklyn which used shell entities and cheap labor[10]—partnered with Andre Agassi to establish a charter school investment fund, the goals of which are charmingly described as:

Provid[ing] investors with current income and capital appreciation by responding to the growing demand for quality charter school facilities in the nation’s burgeoning urban centers and by capturing the opportunities arising out of the current dislocation in the real estate market.[11]

And don’t forget about the other important source of K-12 education privatization, the one happening in public schools themselves. Over the past 15 years the insane rise in the “need” to test our kids, as pushed by the Bush II “No Child Left Behind Act” and other laws, has utterly changed what children actually do when they come to class in the morning. The development of virtually all of this testing and ingenuous technologies to prepare kids for the (same) testing does not come from our school boards or governments, but rather from corporate giants like McGraw Hill and Houghton Mifflin.[12]

Private Prisons. The privatization of prisons in the United States might go all the way back to 1868 when, after the Civil War, southern farmers and businessmen turned to convict-leasing because they needed a replacement work-force for their freed slaves. However, it took the 1980s to really get this business revving.

The U.S. prison population exploded in the 80s due to, among other things, the “War on Drugs” and, soon enough, the first true U.S. corporate-run prisons went on-line in 1984 when the Corrections Corporation of America (“CCA”) took over facilities in Tennessee and Texas.

CCA and its competitors have dramatically expanded since then. Today, about 8% of the total US prison population is housed in privately operated state prisons, mainly in Southern and Western states (although there are private federal facilities too). [13]

Securitization of this “value” has required another stroke of corporate good luck to get moving, namely 9/11 and the resulting mass increase in the detention of immigrants. Since those attacks, CCA stock has gone from a meager $4.75 a share to its price as of this writing of $33.37, a tidy 702% increase. The company now has a total market value of $3.86 billion. GEO Group (formerly Wackenhut Securities) began publicly trading in February of 2002, and its stock has similarly risen from about $5.40 a share to its current price of $33.00 a share, with a market capitalization of $2.36 billion.

This means that in the last 13 years or so, these two companies alone have added around $6 billion of newly securitized “value” to our monetary base by displacing pre-existing public institutions and actively lobbying to increase the national rates of incarceration (see the discussion below regarding ALEC).  Both companies are now actually shamelessly classified for tax purposes as “Real Estate Investment Trusts”. Yes, they no longer even pretend to be working towards the rehabilitation of criminals, they just provide “real estate” services to tens of thousands of “customers” who are involuntary residing in their depressing facilities.  ##[cite Christopher Petrella podcast]

The above stories demonstrate, once again, that to keep the money-making engines primed, it turns out that 1%ers don’t have to extend loans to innovators set on improving people’s lives. Instead, they can just give it to people set on encroaching into once-public spaces.

The Financialization of Politics and De-Politicization of Finance

Money and Politics

As you would expect, all of this plundering of public functions does not happen without corporate lobbyists who pressure and pay our legislators to adopt policies that undermine public functions. Once the cannibalizing industries are in place, the early revenue  they generate can be used to pay corporate lobbyists to push for further legislative changes to grow these “fresh” markets, such as stiffer criminal penalties to benefit private prison owners, and the dictatorial powers given to mayoral-appointed heads of  school systems for them to  close-down struggling inner-city public schools. As a result, our nation’s politics become financialized.

Money has long been part of the diet of American politics, but with the job of a Congressmen increasingly over the last 25 years entailing fund-raising rather than legislating, the issue reached a point of such severity in 2002 that our federal government (shockingly, perhaps, in retrospect) actually did something about it by passing the McCain Feingold campaign finance law. The U.S. Supreme Court’s 2010 decision in Citizens United striking down key parts of that law has become the symbol of the present era of utterly financialized politics, in a way similar to how the court’s 1954 decision in Brown v. Board of Education became the symbol of the (far prouder) civil rights era. In Citizen’s United, the Supreme Court nauseatingly concluded that spending money on political propaganda is on par for constitutional purposes with acts of actual political engagement, in part because corporations are treated for such purposes as “persons” entitled to the same constitutional protections as us human sorts of “persons”. The result has been the formation of Super PACs extravagantly funded by the 1% of the 1% through their personal and corporate treasuries, all for the purpose of propping  up their ever-beholden favorite candidates.

Political financialization has also been dramatically revealed in the workings of the corporate-supported American Legislative Exchange Council (“ALEC”), which, functioning under the guise of a tax-exempt non-profit organization, has crafted cookie-cutter bills for adoption by sympathetic (and well wined-and-dined) member-legislators.

The bills rolling off of ALEC’s conveyor belts are skillfully crafted to benefit the bottom lines of its corporate sponsors such as gun manufactures (e.g. the “Stand Your Ground” laws), the energy-sector (the Koch brothers are huge supporters), and the previously discussed private prison operators and EMOs. ALEC similarly drafted Wisconsin’s law that gutted public-sector collective-bargaining rights, and Michigan’s law preventing unions from including provisions in their contracts that dis-incentivize workers from enjoying union representational services for free, i.e. “Right to Work” legislation.

Just as financialized politics happens when the 99% lack the financial means to compete with this kind of “political engagement”, it happens too when the staggering increases in the amounts of personal debt the system has laid upon the necks of ordinary Americans works to psychologically and socially isolate and disempower them.

There seems to be a surprising scarcity of well-publicized research on the correlation between personal indebtedness and activities like voter participation and civic engagement, but it probably does not take an advanced degree in sociology or psychiatry to figure out that heavily indebted people are frequently depressed and socially isolated, and these traits don’t make any of us a model public citizen.

The contributors to this book have had enough experience with heavily indebted folks (who are included among our ranks) to know that they are frequently socially isolated and often too busy dealing with their own personal miseries to “waste time” thinking about how their predicament might be generalized to the larger society.

In addition, desperation can make people unreliable co-workers when they are pressed by bosses not to unionize.  Terrific recent studies by academics like Daniel Dorling, Kate Picket, and Richard Wilkinson have explained the tight correlations between economic inequality and a wide array of personal and social ills, ranging from worse health (among both the well-off and not), higher crime rates, and general morbidity.

Given this, it is not much of a leap to see that when the financial system uses the 99% as the fodder for its securitization efforts, this not only “makes money” for the 1%, but also commences a negative feed-back loop, the result of which is to sap the 99% of their will to fight back. 

De-politicized Money

What is also under-discussed but critical to the dynamics of the current state of affairs, is the extent to which the inverse of financialized politics is also true: issues concerning how our money is made, cycles through the system, and ultimately flows back to us (or not), have become divorced from politics.

Back in the day, populist champions like Andrew Jackson (who no doubt had plenty of faults too) and William Jennings Bryan achieved wide support expressly campaigning on issues like the merits of having a national bank and the extent to which alternate currencies should, or should not, be permitted to proliferate.

It should thus strike us as intensely odd that, although we are told by pundits that historical levels of discord between the major parties undermine democratic institutions, the fact is that on the issue that might matter most—money—a Martian who knows nothing else about us, but who reviews the pedigrees, policies, and identities of the people at our financial controls, would be hard-pressed not to conclude that it was visiting a single-party autocracy.

The likes of Lawrence Summers, Tim Geithner, Alan Greenspan, Robert Rubin, Ben Bernanke, Jack Lew, and other Wall Street revolving-door wizards and friends have been manning the financial ship for at least 25 years. Their push for free trade agreements, suppression of financial regulations, bail-out of banks, and use of the Federal Reserve solely to manage bank credit (as opposed to facilitating full employment, which its charter also permits[14], has not varied one bit depending on which of the two (supposedly) competing parties has held the presidency.

Come to think of it, it is hard not to get suspicious that all the public acrimony between the political parties might be best explained as a shared preference for government to be dysfunctional so that we are all pushed ever further towards the “private solutions” about which they seem to be in such accord.

We are not suggesting here that all feuding in Congress is strictly for show or that all of the points about which legislators disagree are unimportant.  We are suggesting, however, that sometimes participants in a complex system (think of ant colonies or birds flying in a V-formation) find ways of acting in a manner that furthers the system’s logic and true purposes, even if the individual actors are barely cognizant of the real meaning of the roles they play.

And as a last warning of things to come that might really sound conspiratorial (but it’s true, we swear), beware of the tremendously under-publicized Trans Pacific Partnership Agreement (“TPP”).  It’s a free trade deal that has been in the works for a long time and is allegedly still under negotiation.

The Obama administration has veiled TPP in secrecy, hoping to submit it to Congress on a “Fast Track” basis that would only allow legislators an up-or-down vote, and apparently (from what little the 99% can glean so far) stands to more fully than ever prohibit national legislation that interferes with the flow of capital across international borders or otherwise impedes corporations’ efforts to seize profit-making opportunities with such cross-border investments. Andrew Jackson would be turning over in his grave.[15]

Finally, please realize that none of this uniformity of main stream opinion on the rules governing finance and money is possible without our own unjustified acquiescence to it.

The 1%’s demands that finance be treated as natural science and thus left for the sole consideration of specialists with “successful” investment banking pedigrees (i.e. they made a crap-load of money on Wall Street) or advanced degrees in falsely scientific-sounding fields like “Quantum Finance”.

If you take nothing else from this book, let it be this: that’s bull. Money, throughout history, has always been intensely political. Remember, the same people who want you to treat finance as hard science utterly failed to predict the 2007 collapse!  Putting them on a pedestal is like hailing the guys who, before Einstein thought light travelled through an undetected medium called “The Ether” – guys whose “theories” led to demonstrably false conclusions.

Perhaps even worse, the makers of the present apolitical culture surrounding finance want you to believe that they have learned objective laws regarding the creation and dynamics of money, like those regarding gravity, quantum mechanics, or other sub-specialties of the physical sciences.  They have not. Money is neither created nor flows naturally, but does so according to the rules and contours that we (the people) establish for it.

 


[1]              Matt Taibbi, “The Scam Wall Street Learned From the Mafia”, Rolling Stone, June 12, 2012 (www.rollingstone.com/politics/news/the-scam-wall-street-learned-from-the-mafia-20120620#ixzz1yTEU6EWm.)

[2]              Matt Taibbi, “Looting Main Stream”, Rolling Stone, March 31, 2010, (www.rollingstone.com/politics/news/looting-main-street-20100331).

[3]             “Bank Swap Deals Continue to Cost Philadelphia City, School District”

                The Pennsylvania budge and Policy Center, January 17, 2012

(www.pennbpc.org/bank-swap-deals-continue-cost-philadelphia-city-school-district.)

[4]              Harold Brubaker, Philadelphia sues big banks for swap losses”, July 31, 2013, Philly.com. www.articles.philly.com/2013-07-31/business/40897826_1_interest-rate-swaps-london-interbank-offered-rate-libor)

[5]            Rachel Layne & Justin Doom, “KKR to Goldman Breach Water Deal Dam in U.S. Commodities”, Bloomberg, May 8, 2013.

(http://www.bloomberg.com/news/2013-05-07/kkr-to-goldman-breach-water-deal-dam-in-u-s-commodities.html)

[6]              “Hospital Corporation of America”, Wikepedia.

[7]            Jonathan Kozol “The Big Enchilada” Harpers’ Magazine, August 2007.

[8]              “Canyon Agassi Charter School Facilities Fund”

(www.agassi.com/canyon-agassi-charter-school-facilities-fund)

[9]              “EdisonLearning”, Wikepedia.

[10]           HRH Bankruptcy Proceedings, SDNY Bankruptcy Court; see also Sonya Eskridge, “Magic Johnson Cheating Labor  Unions“, S2Smagainze.com, September 23, 2011

(http://s2smagazine.com/11254/magic-johnson-cheating-labor-unions/)

[11]           “Canyon Agassi Charter School Facilities Fund”

(www.canyonagassi.com).

[12]           “The Testing Industries Big”, Front Line. (www.pbs.org/wgbh/pages/frontline/shows/schools/testing/companies.)

[13]           “Private Prison”, Wikipedia; see also Bernard Harcourt, “The Illusion of Free Markets, Laissez faire and Mass Incarceration”, University of Chicago Law School Podcast Lecture Series, May 11, 2011; see also “About Private Prisons” Texas Prison Bind’ness, March 21, 2007 (www.texasprisonbidness.org/about-private-prisons).

[14]          Lauren Paer, “Misdiagnosis and Malaise: Why the Fed Has Failed to Aid the Job Market”, Kennedy School Review, 2013 Issue.              (www.harvardkennedyschoolreview.com/category/2013)

[15]           Flush the TPP website (http://www.flushthetpp.org/)

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The Dirty Dozen: Legal Outrages

If serious prosecutions of fraud by Wall Street firms are never brought, the public’s suspicion about Washington’s policies toward bankers will only grow, as will cynicism about the rule of law as it is applied to the rich and powerful.”[1]

 

Jeff Madrick and Frank Partnoy

 

The past decade has seen a broad assortment of legal outrages. Wall Street firms have flagrantly violated the law. Often they are not prosecuted at all. When they are, they typically receive a slap on the wrist that will not deter future wrong-doing. At the same time, Congress has passed laws and regulators have written regulations that further entrench Wall Street’s interests. The following are some of the worst.

1. HSBC Laundering Money for Terrorist Organizations and Drug Cartels

Hongkong and Shanghai Bank Corporation (HSBC) laundered billions of dollars for Al Qaeda, Iran, Mexican drug cartels and similar “clients.” When warned by regulators or reported by news media, HSBC alternately denied the activity or said they would stop it. Instead, they allowed it to continue for at least a decade. In fact, an HSBC whistleblower claims it is still going on.[2] (see Chapter 2).[3]

2. 2005 Bankruptcy Law

In 2005, Congress revised the bankruptcy law to make it much more “creditor-friendly.” This is to say, good for the banks, bad for the borrower. To give one example, judges are no longer allowed to reduce amounts owed on student loans to private lenders, even if the schools are scamming for-profit “degree mills”.[4] Lo and behold, in 2010, student loans pulled ahead of credit-cards as a form of 99% indebtedness. [5]

3. LIBOR Manipulation

Although it is obscure, the London Interbank Offered Rate (LIBOR) is crucial to trillions of dollars of financial instruments—quite possibly including your mortgage, your credit card or your city’s borrowing. Despite its incredible importance to rates around the world, LIBOR is set through casual communications among banks, and traders routinely adjusted these “communications” to benefit one another. They basically skewed the entire international financial system for personal gain.

This episode epitomizes two things about Wall Street. First of all, this was done by traders without apparent oversight. It is not clear that the banks involved actually benefited. But, the traders did increase their own bonuses. A trader has even been quoted as saying, “It’s us against the bank.”[6] The bank in question was his employer. Clearly, the mega-banks are unable to govern themselves. Second, this behavior happened at many banks in several countries.  It was so common that traders felt no compunction about putting damning statements in e-mail messages.  For traders, their bonus is paramount, obligations to their employer are secondary, and consideration of other people is not even on the radar screen.

4. Repeal of Glass-Steagall

After the Great Depression, reforms were put in place to restrict banks from taking risky positions with depositors’ money or with funds borrowed from the Federal Reserve. This reduced the frequency of bank failure for fifty years. But beginning in the 1980s, many of these restrictions were removed, with the capstone being the Gramm-Leach-Bliley Act of 1999. More specifics of this sad history are discussed in Chapter 4.

5. Too Big to Fail / Too Big to Jail

There is a widespread belief that failure of one of the largest banks or other financial institutions could have catastrophic consequences for the economy. Rather than trying to address this threat, the fear of these consequences has been used as justification for bailing out these institutions when they get into trouble (see Chapter 2). President Obama and his administration will claim that this problem was addressed by the Dodd-Frank Wall Street Reform Act. But even the Fed does not believe it. In a major speech on the topic, Federal Reserve Board member William Powell noted,  “Success is not assured.”[7] This is Fed-speak for “we have our fingers crossed.” Richard Fisher, President of the Dallas Federal Reserve Bank, is more forthright; he says the banks are still too big, practice crony capitalism, and need to be broken up.[8]

Even worse, too big to fail has been used as an excuse not to prosecute banks even when they admit to a long history of criminal activity (see point 12 below, “Lack of Accountability”).[9]

In addition to the injustice of all that, because the megabanks are deemed too big to fail, they can borrow at lower interest rates—in essence, this is a subsidy worth tens of billions of dollars to the banks every year.[10]

6. Special Tax Break for Hedge Fund and Private Equity Managers

Hedge fund managers and private equity executives get a big break on their personal income tax. They pay about half of the ordinary tax rate because their income is deemed to be long-term capital gains subject to a preferential rate—even if it really isn’t.[11]

This is called “carried interest” treatment.[12]

7. Commodity Futures Modernization Act of 2000

In the 1990s, instruments called “derivatives” were traded outside of public view and often without regulatory oversight in volumes representing more money than the entire world economy. Brooksley Born, then head of the agency with authority to regulate most derivatives, tried to include these within the agency’s scope. This effort was squashed first through the combined efforts of Treasury Secretary Lawrence Summers and Fed Chairman Alan Greenspan, and then by Congress in this so-called “Modernization” Act (see Chapter 4).

8. Privatization of Fannie Mae and Freddie Mac

Fannie Mae was created as a government agency in the 1930s to foster the issuance of long-term fixed-rate mortgages. It served this purpose well for nearly 50 years. But in the 1970s, Congress decided to privatize it. They did the same with Fannie’s brother “Freddie Mac” shortly afterward. As private companies, they paid their shareholders tens of billions of dollars in dividends by taking enormous risks. But, when the risks turned sour, Fannie and Freddie were deemed “too big to fail” and considered “government sponsored enterprises” and so we, the taxpayers, got to absorb their hundreds of billions of dollars in losses.

9. Fiduciary Obligations of Pension Trustees

Trustees of pension funds might appropriately be concerned not just about the financial returns on investments they secure for participating employees—but also on whether the industries the employees work in survive, or for that matter, whether the world they live in survives. Which means the trustees may want to avoid investing in companies that are engaging in unsavory labor practices, war profiteering, or are contributing to climate change. The plan beneficiaries might in fact agree with these criteria. But, fiduciary obligations have been interpreted to pretty much prevent trustees from considering such “non-financial” factors. This means that the financial criteria that are generated by Wall Street to evaluate investments are effectively all the trustees are allowed to consider when investing trillions of dollars of the 99%’s savings.  The harm that may be done by the companies invested in is considered irrelevant.[13]

10 Robo-signing and the Settlement

After the collapse of the housing market, banks had many mortgages in default. When they took the bail-out money, the banks assured the government that they would work with the borrowers to make the best of the situation. Working with the borrowers would also have been good for banks, in many cases, because it is often more profitable to adjust a mortgage of an existing borrower who is behind, than to try recouping the money on the delinquent loan by selling the house in foreclosure.

Because of the extensive securitization of mortgages, it often wasn’t clear which institution had title to the loans. The law required the banks to work through the documentation and figure it out. But many banks decided neither to work with borrowers nor go through the pain-staking process of lawfully foreclosing on them. Instead, they hired unqualified people to sign documents without reading them so that foreclosures could proceed quickly. This came to be called the robo-signing scandal.

When the robo-signing scandal came to light, the banks were let off with light settlements and no prosecutions.

11. Companies Are Just Like People … Until They Owe Money

Another not sufficiently discussed, but sadly entrenched, outrage in the law is the use of corporations as a means to run from commercial debts. In a very real sense, that is what the law understands corporations are for. As we have discussed, especially since the 2005 bankruptcy amendments, the ability of human beings to get out from under their debts, especially loans to pay for college, is almost non-existent. Mitt Romney (and the Supreme Court in its Citizens United decision), have told us that “corporations are people,” but it turns out that this is not entirely true. People get stuck with the consequences of their promises (at least the 99% does); corporations do not.

Consider, for example, the fact that a human (as opposed to a “corporate”) person can pretty much give away all of his future earnings by signing papers that obligate him to a huge student loan or a home mortgage that he can’t really afford.  Say what you may about whether someone should sign such documents, a signature on a loan or a mortgage means what it means: you are obligated to repay.

This is not so for corporations.  Because they are really not things at all, but just names on registries, they can easily go out of business, leaving whomever they owed money to, such as their workers, in the lurch.  Indeed, when principals of companies (in rare cases) try to back-up the promises of the companies they create by saying they will be personally liable for the corporate debt— courts often won’t let them.  Even when the language they have signed agreeing to do this is crystal clear.

Similarly, companies will almost never be found responsible for one another’s debts even if it is overwhelming clear that they are run by the same people, using the same phone numbers, and sharing the same office. Again, the motivation here is that companies are entities that are designed to run-up debts. Absent extraordinary circumstances, courts will not undermine that purpose by doing something so “inefficient,” so “socialistic,” as holding the humans behind the companies responsible for the damage to society that their corporate creations inflict, even though we know it is these same human principals who stand to benefit on the upside if their companies succeed. If only it were so easy for the broke students who never got the benefit of a good job after graduation to get out of the bet they took in going to college.[14]

12. Lack of Accountability and Prosecution

After running up billions of dollars in losses in their companies and trillions of dollars in “collateral damage” to the economy, the megabanks were not required to replace their CEOs or other senior executives. Not only did the CEOs keep their jobs, they even kept their bonuses, their stock options, and their corporate jets.

In many cases, the CEOs should have been prosecuted. Although some people admit that there were regrettable acts, they still argue that few of these acts were actually illegal. This is not true. We provide a list of some of the crimes below. Despite this extensive law-breaking, there were actually fewer criminal prosecutions after 2008 than after the comparatively tiny 1980s savings and loan scandals (see Chapter 4). In many cases since 2008, no prosecution was brought at all. In others, there was a settlement on terms that amounted essentially to a slap-on-the-wrist. What’s worse, none of the senior executives was prosecuted.

Although some try to justify the inaction or light penalties by arguing it would have been hard to prove the crimes, this is not an adequate excuse. First of all, as former prosecutor Neil Barofsky noted when he met with Alternative Banking, it is a prosecutor’s job to try hard cases. But secondly, it shouldn’t have been so hard. After the bubble in Internet stocks of the 1990s, Enron’s massive book-keeping fraud, and other corporate accounting scandals, Congress passed the Sarbanes-Oxley Act specifically to make senior executives liable for crimes committed by their companies.[15]

The salt in the wound has been that after seeing the bankers get away with all this, we now get to hear the U.S. Attorney General, Eric Holder, explain why. Holder noted that “I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them”[16], specifically because their immensity means any harm to them will harm the economy. They are just too big and too important to be bothered with having their crimes punished. They are literally “too big to jail.” Lack of prosecution, or inadequate prosecution, only encourages continued law-breaking.

 


[1]               Jeff Madrick and Frank Partnoy, “Should Some Bankers Be Prosecuted”, New York Review of Books, November 10, 2011

                http://www.nybooks.com/articles/archives/2011/nov/10/should-some-bankers-be-prosecuted/?pagination=false

[2]               Marni Halasa, “Is Anybody Listening? HSBC Continues to Launder Money for Terrorist Groups Says Whistleblower” Huffington Post, August 28, 2013

http://www.huffingtonpost.com/marni-halasa/is-anybody-listening-hsbc_b_3831412.html

[3]               “HSBC money laundering report: Key findings”, BBC News, December 11, 2012

http://www.bbc.co.uk/news/business-18880269

[4]               Kayla Webley, “Why Can’t You Discharge Student Loans in Bankruptcy?” Time Magazine, February 9, 2012

http://business.time.com/2012/02/09/why-cant-you-discharge-student-loans-in-bankruptcy/

[5]              Mark Kantrowitz, “Total College Debt Now Exceeds Total Credit Card Debt”, fastweb.com, August 11, 2010.

http://www.fastweb.com/financial-aid/articles/2589-total-college-debt-now-exceeds-total-credit-card-debt

[6]               John Lanchester, “Let’s Consider Kate”, London Book Review, July 18, 2013

                http://www.lrb.co.uk/v35/n14/john-lanchester/lets-consider-kate

[7]           Governor Jerome Powell, “Ending ‘Too Big to Fail’”, Institute for International Bankers 2013 Washington Conference, March 4, 2013

http://www.federalreserve.gov/newsevents/speech/powell20130304a.htm

[8]           Pedro Nicolaci da Costa, “Richard Fisher Says Too-Big-To-Fail Banks Need to Be Broken Up”, Huffington Post, March 16, 2013

http://www.huffingtonpost.com/2013/03/16/fisher-too-big-to-fail_n_2891452.html

[9]               PBS Frontline, “The Untouchables”, January 22, 2013

http://www.pbs.org/wgbh/pages/frontline/untouchables/

[10]             Dean Baker and Travis McArthur, “The Value of the ‘Too Big to Fail” Big Bank Subsidy”. Center for Economic and Policy Research, September, 2009.

                http://dspace.cigilibrary.org/jspui/bitstream/123456789/25806/1/Too%20big%20to%20fail%20-%20bank%20subsidy.pdf?1

[11] Jacob Goldstein, “Carried Interest: Why Mitt Romney’s Tax Rate Is 15 Percent”, January 19, 2012.

http://www.npr.org/blogs/money/2012/01/19/145449117/carried-interest-why-mitt-romneys-tax-rate-is-15-percent

 

[12]             The preferential treatment of capital gains should not exist at all. It is not at all clear why capital should be taxed less than labor. What’s more, it creates opportunities for tax gimmicks. Reagan abolished in 1986 with no ill effects. It was brought back under Bush I but, even if there is a preferential rate for capital gains, it is clear that carried interest should not qualify.

[13] Mason Tenders Dist. Council Welfare Fund v. Thomsen Constr. Co., 301 F.3d 50, 52 (2d Cir. N.Y. 2002)

[14] See Donovan v Bierwirth 680F.2d 263 (2d Cir. 1982)

[15] Marian Wang, “Why No Financial Crisis Prosecutions? Ex-Justice Official Says It’s Just too Hard”,

ProPublica, Dec. 6, 2011

                http://www.propublica.org/article/why-no-financial-crisis-prosecutions-official-says-its-just-too-hard

“Prosecuting Wall Street”, 60 Minutes, December 4, 2011

                http://www.cbsnews.com/8301-18560_162-57336042/prosecuting-wall-street/?tag=contentMain;contentBody

Jeff Madrick and Frank Partnoy, “Should Some Bankers Be Prosecuted”, New York Review of Books, November 10, 2011

                http://www.nybooks.com/articles/archives/2011/nov/10/should-some-bankers-be-prosecuted/?pagination=false

[16] Mark Gongloff, “Eric Holder Admits Some Banks Are Just Too Big To Prosecute”, Huffington Post, March 6, 2013

http://www.huffingtonpost.com/2013/03/06/eric-holder-banks-too-big_n_2821741.html

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A Little History to Explain a Lot of Tragedy

This bill will also, in my judgment, raise the likelihood of future massive taxpayer bailouts. It will fuel the consolidation and mergers in the banking and financial services industry at the expense of customers”. [1]

Senator Byron Dorgan

Expressing opposition to the bill that removed  Glass-Steagall restrictions in 1999


Our recent and current crisis was the worst economic downturn since the Great Depression and has been aptly named the Great Recession. Experts and talking heads have credited a wide variety of factors as causes of the crisis. But there are three key dates that actually tell much of the story. Those are 1933, when the Glass-Steagall Act (“Glass-Steagall”) was passed, 1999, when it was repealed, and 2000, when Congress effectively banned the regulation of derivatives. Sometimes, history does come darn close to repeating itself.

The 1929 Crash and Glass-Steagall

The stock market crash of 1929 was arguably the worst disruption ever of American financial markets, and it soon led to the catastrophic Great Depression, in which unemployment ballooned from 3.2% in 1929 to 25.2% in 1933.[2] The capital markets similarly floundered after the market crashed, when issuance of corporate securities shriveled from $9.4 billion in 1929 to a mere $380 million in 1933.[3]

In 1932, Congress commissioned Ferdinand Pecora to lead a thorough investigation of the 1929 crash, with the hope of providing guidance to lawmakers on what kind of legislation might avert similar outcomes in the future. One of the Pecora Commission’s key findings was that, leading up to the crisis, investment banks were precariously involved in speculative securities, effectively using the deposits of the ordinary people and businesses who were their customers. Rather than keeping depositors’ money in a vault (or at least in a safe financial instrument), banks were essentially gambling with it and keeping the profits for themselves.

The Commission concluded that the conflict “between the business of marketing securities and the business of protecting depositors’ money” was a key support for the cause of reform.[4] , which, not long afterward, led to the passage of the Glass-Steagall Act of 1933 (“Glass-Steagall”). Generally speaking, the Act restricted commercial banks (i.e. banks that take deposits and issue loans) from engaging in securities dealing as investment banks do (i.e. trading securities for profit).

Glass-Steagall was an unqualified success. From 1797 to 1933, the American banking system crashed about every 15 years. In contrast, during the first half-century after Glass-Steagall, there were barely any bank failures at all.[5] And yet despite this unprecedented financial stability, Glass-Steagall continually provoked fierce detractors who pined for access to the trillions of dollars of depositor money that was sitting in relative safety at commercial banks. In addition, these detractors jealously eyed the flood of capital flowing to banks through the Federal Reserve’s discount window and other monetary programs. At the same time, commercial banks became bored with the incremental profit margins that they could earn from traditional banking and craved the higher earnings that riskier investments offered. But, of course, it was precisely to prohibit such mixing of bank speculation and depositors’ capital that Glass-Steagall had been enacted.

Undeterred, banks kept pushing, and in the 1980s, with the advent of President Reagan’s pro-business supply-side economic policies (known as “Reaganomics”), the bankers began to get their way. Reaganomics brought widespread financial deregulation, including, perhaps most significantly, the financial lobby’s success in convincing the nation’s banking regulators to puncture Glass-Steagall with numerous loopholes and exemptions. As a result, commercial banks began engaging in riskier activities, and, not surprisingly, the late 1980s brought a sharp spike in bank failures. This trend can be seen in the chart below, which chronicles the number of bank failures since 1934, as reported by the Federal Deposit Insurance Corporation.

Source: Federal Deposit Insurance Corporation (FDIC)

This data plainly shows a long period of financial stability following Glass-Steagall’s passage, which then reverses once financial deregulation sets in. It also shows a period of “quiet before the storm” leading up to 2008, with zero recorded bank failures in 2005 and 2006.

The steady gutting of Glass-Steagall continued from the 1980s until its final death knell in 1999, which is when the Gramm-Leach-Bliley Act officially repealed Glass-Steagall, allowing investment banks and commercial banks to once again merge, pool assets, and co-mingle the monies of ordinary depositors with speculative trading operations, as in the pre-Great Depression days. Banks could (and did) return to the good old days of treating assets they held in trust for common depositors as resources available to underwrite higher yielding, riskier securities transactions, with no obligation to share the upside. The problem was that, once again, all the risk on the downside would be everyone’s problem. Freed from the regulatory shackles of Glass-Steagall, banks took risks of increasing magnitude and complexity. And just in case more cheap (virtually free) cash was needed, the Federal Reserve, under the Chairmanship of Alan Greenspan, made absolutely no effort to pushback against the growing speculative tide. Instead, the Fed fueled speculation by lending to banks at very low rates.

Deregulation, Derivatives, and Brooksley Born

Perhaps needing to shield a more sophisticated public from the degree of risk associated with its behaviors (after all, perhaps folks still remembered some of the lessons from 1929), the banks’ betting strategies increasingly relied on “financial innovations” which mainly served to conceal what they were up to.

As has been discussed in previous chapters, the concept of a mortgage changed from a relatively simple two-party contract into a multi-party apparatus involving layers upon layers of transactions, pass-through entities, and servicers. Bundles of mortgages were pooled together, forming the collateral for new “mortgage backed securities” (MBS). These, and various other instruments that “derived” their value from other financial arrangements, became known as “derivatives.” The risk associated with these and other new-fangled financial products could often be sold in the form of credit derivatives, which further shifted risk away from the original mortgage lender to unknown, distant parties.

Needless to say, the more complex the transactions grew, the more lucrative this was for the investment banks, such as Bear Stearns and Goldman Sachs, which had created them. Like the cost of any highly technical thing, banks charged higher commissions for each level of added complexity. While there is a story that bankers liked to tell about how these products grew the economy by lowering the risk of individual bad loans through their “pooling” with hundreds of other good and (even more) bad ones, a comprehensive survey of empirical economic data has revealed little evidence of such a benefit.[6]

Paul Volcker, the former head of the Federal Reserve Bank, may have expressed it best when he quipped that the most important innovation in finance over the last twenty years was actually the ATM. Volker lamented: “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth—one shred of evidence.”[7] And the nation’s leading private investor, Warren Buffet, memorably labeled the new derivative instruments “weapons of mass destruction.”

Much, but not all, of the risk of derivatives came from the fact that banks had virtually no obligation to disclose how many of them they held. As a result, they were able to massively shield their financial health from their many creditors. Derivatives are typically traded off the market, in an agreement between two parties that remains known only to them. This is known as “over-the-counter trading.” These derivative trades are not on exchanges and, typically, nobody (except, just maybe, the parties) knows who owns what or how much anything is currently “worth.” In short, there is absolutely no transparency.

These off-exchange transactions began accounting for an increasing percentage of all trading done by major banks and other financial entities like AIG. Since nothing about them has to be reported, it becomes impossible to know how heavily involved a particular bank or hedge fund might be in a risky deal.

It was not just Paul Volcker and Warren Buffet who recognized the potential for systemic disaster lurking in these hidden trades. In the late 1990s, Brooksley Born was the Chairperson of a small federal agency, the Commodity Futures Trading Commission (CFTC).  She had an understanding of derivatives from her work as a lawyer in the financial world and believed that the sheer volume of derivatives trades coupled with the government’s complete ignorance of what was taking place presented a serious problem. Indeed, it lay at the heart of the unexpected 1998 collapse of the hedge fund, Long Term Capital Management.

Brooksley Born proposed that the CFTC, which regulated other derivatives, create regulations which would permit authorities to at least know what was happening and outlaw certain practices which contributed to instability. In a remarkable narrative of power overcoming good faith and reason, the story ended poorly. She was setupon by the biggest guns of the governmental financial establishment, most notably Robert Rubin and Lawrence Summers, then Secretary and Deputy Secretary of the Treasury, respectively, and Allen Greenspan, then Chairman of the Federal Reserve. Her proposal was decisively defeated.

Born resigned in June 1999. Not long afterward – and with the staunch support of the just-mentioned Clinton-era financial gurus – Congress, as if responding to a national emergency, hastily passed The Commodity Futures Modernization Act of 2000. The CFMA is a remarkable piece of pro-business legislation that virtually bans government regulators from gathering information on, investigating, or making rules pertaining to, derivatives. The law essentially mandates a complete “Hands Off” approach to these transactions despite the fact that a core principle of Wall Street free-market champions is that only with full and free information can markets ever be expected to function productively in the first place!

Indeed, only a few years later derivatives, and the inability of financial institutions to assess the risk posed by them were main contributors to the freezing of international credit markets and the resulting economic meltdown of 2008. And yet even today, the derivative market remains opaque and unregulated.

Thus, in the run up to 2008—with Glass-Steagall gone and the effort to create even a modest regulatory structure for derivatives crushed—banks were engaging in more complicated, riskier, and less transparent behavior than ever before.[8] And so, in retrospect (as understood by a very small community of economists), the crisis was not just the kind of thing that is going to happen now and again as a result of the haphazard economic forces in a capitalist society. Rather, the gutting of the Glass-Steagall Act and other deregulatory maneuvers would be equivalent to the blind mismanagement of a forest system left to grow dense fire-sensitive ground cover. We might not know just when the spark is coming, but can we really act surprised when it hits or feign shock at the extent of the catastrophe it unleashes?

Recent Attempts to Approximate the Glass-Steagall Standard

In 2010, in response to the crisis, Congress did do something: it passed the Dodd-Frank Act (Dodd-Frank) to implement some restraints on banking and financial activities. We should point out the Dodd-Frank fell far short of what many felt was needed. Nonetheless, there were useful parts to and a key provision was Section 619, commonly known as the “Volcker Rule,” named, yes, after the same former Fed Chairman, Paul Volcker, noted above.

Volcker had been one of the most prominent critics of the repeal of Glass-Steagall, perhaps because he had been around long enough to live the history we just described. Volcker began working as an economist at the Fed in 1949, led the organization during the tumultuous stagflation days of the 1970s, and, in his old age, had become a “wise-man” of sorts on Wall Street (however oxymoronic that may sound). In an uncharacteristic choice of someone outside the core community of the revolving door group of bankers-today-regulators-tomorrow, Obama brought Volcker to the White House during his first term to serve as the head of his Economic Recovery Advisory Board.

In 2009, Volcker presented Obama with a two-page white paper that outlined a modern-day version of Glass-Steagall. The proposal involved placing limits on proprietary trading (e.g, self-interested securities trading, or speculation) by regulated commercial banks. Obama actually adopted Volcker’s idea in January 2010 and christened it the “Volcker Rule.” It is vital to note that neither Glass-Steagall nor the Volcker Rule ever put limits on securities trading by traditional broker dealers or investment banks. Rather, these laws only sought to address the glaring conflict of interest recognized by Ferdinand Pecora eighty years ago: a bank that benefits from public money (whether in the form of customer deposits or Federal Reserve loans) should not be permitted to gamble with that money in the highly speculative manner characteristic of investment banks or securities traders.

By the time the Volcker Rule made its way from the President to Congress in the summer of 2010, deregulatory interests had already prevailed in riddling it with numerous loopholes and exemptions. As a result, the final version of the Rule that was passed as Section 619 of Dodd-Frank in July 2010 bore little resemblance to the simple proposal that Volcker had originally presented.  For instance, while the Rule prohibited proprietary trading by commercial banks, it permitted such banks to engage in “market-making,” which involves taking the opposite position on a customer’s securities order in order to prop up the market for that security. Unfortunately, the market-making exemption can be easily exploited, especially in cases of highly illiquid over-the-counter (OTC) securities that have no real market. For such securities, a purely speculative trade by a bank can be easily disguised as an attempt at “market-making.” The Volcker Rule’s exemption for “hedging activities” presents a similar problem.

The five federal agencies charged with implementing the Volcker Rule — the Fed, the SEC, the CFTC, the OCC, and the FDIC (the Agencies) — issued proposed regulations in October 2011, shortly after the inception of the Occupy Wall Street movement.  Under the Administrative Procedure Act (APA), any “interested party” affected by a federal agency’s proposed rule can submit a public comment to the agency, and, by law, the agency is required to consider such a comment before finalizing the rule. A significant amount of corporate lobbying exists at this level of would-be lawmaking, which, given the obligation of the Agencies to consider everything submitted to them, can pretty much drown the process in paperwork.  As recently reported in the National Magazine, the flood of such comments from the financial industry, along with the crushing flow of financial sector lawsuits the government has had to defend (at taxpayer expense) has pretty much thwarted implementation of the 2010 law.

One Occupy group, Occupy the SEC (OSEC), has recognized the inordinate lobbying pressure that was being placed on the Agencies (from banks, politicians, and even foreign countries) to gut the Volcker Rule, so it decided to fight fire with fire by submitting its own 325 pages of comments, which were submitted in February 2012. Those comments took issue with loopholes and exemptions that could be found in the proposed regulation and suggested regulatory changes that would strengthen the Volcker Rule’s containment of bank excesses. As of this writing, the Agencies have yet to issue final rules implementing Section 619, which means that banks continue to pose many of the same systemic risks that caused the 2008 crisis. In addition to submitting comments, OSEC has also brought a federal lawsuit in the Eastern District of New York against the Agencies (and also the Department of the Treasury) for their delay in finalizing the Volcker Rule. [9] That legal challenge remains pending.

If implemented in a form that is similar to the proposed version that came out in October 2011, the Volcker Rule would merely be a middling half-step towards reinstituting the sweeping safeguards that Glass-Steagall originally imposed. That is, the Rule would certainly improve the status quo because many types of overt proprietary trading would be prohibited, but it would not be the case that we have successfully re-learned the lesson of the 1929 crash and kept banks from betting widely with consumer deposits and the essentially public monies made available to them at the Fed’s discount window. Given the breadth of the Rule’s market-making, hedging, and securitization exemptions, many unsafe banking practices would still continue unabated. Of course, as noted, even the watered-down text of 2010 financial reform legislation has come to naught because of massive bank obstructionism, led by none other than Eugene Scalia, son of Supreme Court Justice Anton Scalia, and a Washington DC partner at the global law firm of Gibson, Dunn & Crutcher.  Unfortunately, we stand no better protected today than we did before the 2008 collapse.

Senator Elizabeth Warren has tried to address the Volcker Rule’s deficiencies by proposing a new version of the Glass-Steagall Act. Remarkably, Republican Senator John McCain is a co-sponsor of her bill.[10]  As of this writing, the bill seems very unlikely to pass, despite tepid support from some Wall Street veterans like Sanford “Sandy” Weill, former Chairman of Citigroup, who is widely credited as the mover-and-shaker behind the repeal of Glass-Steagall during the late 1990’s.

The nation’s financial system continues to be at risk so long as the Volcker Rule — Section 619 — is a weak substitute for Glass-Steagall and, even in that watered-down form, remains unimplemented. Unfortunately, even if the Volcker Rule eventually becomes law in a form vaguely resembling the 2010 Congress’ intent, banks will, to a considerable extent, still be able to engage in speculative trading funded by public money. Only a full return to the Glass-Steagall standard originally championed almost a century ago would appropriately safeguard the interests of depositors, average investors, and the public generally as the true intended beneficiaries of Federal Reserve lending activities. Such a return seems unlikely at this stage, which means that the 99% has yet to adequately express its indignation and outrage about the regulatory work that needs to be done to avert the next Great Recession.


[1]       James Lavin, “Many warned deregulation would cause financial crisis & taxpayer bailouts”, jameslavin.com, March 26, 2009

http://jameslavin.com/articles/2009/03/26/many-warned-deregulation-would-cause-financial-crisis-taxpayer-bailouts/

[2]              Steven A. Ramirez, Arbitration and Reform in Private Securities Litigation: Dealing with the Meritorious as Well as the Frivolous, 40 Wm. & Mary L. Rev. 1055, 1066 (1999).

[3]               Ibid.

[4]               Statement by Senator Frederic Walcott, 75 CONG. REC. 9904 (1932))

[5]               Interview with Elizabeth Warren, CNBC, Jul. 12, 2013, available at http://video.cnbc.com/gallery/?video=3000182337.

[6]             See W. Scott Frame & Lawrence J. White, “Empirical Studies of Financial Innovation: Lots of Talk, Little Action?”, 42 J. Econ. Lit. 1 (2004).

[7]            Interview with Satyajit Das, “The Financial Zoo: An Interview with Satyajit Das – Part I, Naked Capitalism, Sep. 7, 2011, http://www.nakedcapitalism.com/2011/09/the-financial-zoo-an-interview-with-satyajit-das-%E2%80%93-part-i.html (last visited Nov. 12, 2011) (“US financial services increased its share of value added from 2% to 6.5% but is that a reflection of your financial innovation, or just a reflection of what you’re paid?”).

[8]           Even sophisticated parties may not be aware of or fully appreciate the risks involved in their own activities. For example, Long Term Capital Management was managed by Nobel-prize winning economists and financial modeling experts, and yet it failed in epic fashion in 1998, almost taking the economy down with it. See Roger Lowenstein, “When Genius Failed: The Rise and Fall of Long-Term Capital Management(2001).

[9]              Paul McMorrow, “Occupy the SEC Takes on Big Banks on Their Own Turf”, Boston Globe, Mar. 5, 2013, available at http://www.bostonglobe.com/opinion/2013/03/05/occupy-sec-takes-big-banks-their-own-turf/xRmDFTt81dTpuP1CJzio5O/story.html

[10]               Carter Dougherty & Cheyenne Hopkins, “Warren Joins McCain to Push New Glass-Steagall Law for Banks”, Bloomberg, Jul. 12, 2013, available at http://www.bloomberg.com/news/2013-07-11/warren-joins-mccain-to-push-new-glass-steagall-bill-for-banks.html.

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New Money

What is money or currency? 

Imagine, you are on a deserted island all you have on you is your wallet. After a long day of searching for food and water you find a bag of diamonds and a chest of gold. Next day, the story repeats: another bag of diamonds and another chest of gold but no food no water. The question is, what all the riches are good for if you can’t not buy food and water.

Money, in and of itself, is nothing. It can be a shell, a metal coin, or a piece of paper, but the value that people place on it has nothing to do with the physical value of the money. Money derives its value by being a trusted medium of exchange, a unit of measurement. Money allows people to trade goods and services indirectly, understand the price of goods (prices written in dollar and cents correspond with an amount in your wallet) and gives us a way to save. Money is valuable merely because everyone knows everyone else will accept it as a form of payment.

The US dollar has this privilege. It is our official currency (or money). Generally speaking, each country has its own currency. For example, Switzerland’s official currency is the Swiss franc, and Japan’s official currency is the yen. An exception would be the euro, which is used as the currency for several European countries.

Complementary Currency

Currencies suffer from monoculture, much like in agriculture, when a single crop such as corn is over or under produced. It’s thought by some monetary thinkers like Bernard Lietaer, who is a monetary theorist involved in the talks on the ECU that ultimately led to the Euro, that this is the cause of most of the risk and instability in the monetary system, which leads to crisis [1].

In 1934 Switzerland there was depression and shortage of credit. A small group of independent small to medium size businessmen were faced with severe shortage of money, as well as the strong competition of the larger businesses and corporations, all fighting for the shrinking markets. One day when they no longer were able to pay each other because banks refused to extend the line of credit, the businessmen joined together to form a ‘internal credit’ organization called the WIR Cooperative. They created a currency called WIR based on trust they have built throughout the years working together and (not to be naive) also on issued invoices payable in a defined time frame [2].

Did you know that WIR is still in use till this day along the side of the well known Swiss franc? And there thousands of what’s called complementary currencies in use through out the world. When Central banks fail, people in communities come up with ways of supporting and doing business with each other. It mobilizes their own credit potentials without using commercial banks as intermediaries. Also, it has been successful at protecting small and independent businesses against growing pressure from large, financially strong competitors. Local or community currencies by its virtue prevent outflow of capital and profits to the large chain stores, department stores, stock corporations.

One of the key features of currency is trust. Look around and you will find people whom you trust. If there is trust there could be a currency. A group of new moms in Madison (WI) came up with an idea of using popsicle sticks to keep track of hours watching each other other’s kids. That was the birth of the Madison Eastside Babysitting Coop*.

There are multiple examples of community based currencies. Just to name a few:

  • Ithaca Hours (New York),
  • BurkShare (MA),
  • Trade Dollars (AK),
  • Cascadia Hours (OR),
  • Downtown Dollars (PA)
  • LET (Canada)

To find out more go to Schumacher Center for a New Economics [3] and start your own currency.

  1. Rethinking Money, How new currencies turn scarcity into prosperity by Jacqui Dunne and Bernard Lietaer
  2. Robert Swann Essential Essay on Local Currencies (http://centerforneweconomics.org/publications/authors/Swann/Robert)
  3. Schumacher Center for a New Economics. Directory of active US, Canadian, Mexican and European local currencies http://centerforneweconomics.org/content/active-local-currencies

* To look for a coop in your area or learn how to start one go to https://www.sittingaround.com

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