We’ve heard a lot about financial institutions that are “too big to fail”
and so must be propped up with taxpayer dollars when they run into trouble.
My question:
“If they are ‘too big to fail’,
why are they not broken up into smaller pieces?
Remember the ‘trust-busters’ of the progressive era?
Why are the same principles not being applied now?”



But Who Is Watching Regulators?
New York Times, 2009-09-15

Regulators seek tighter oversight of derivatives
Associated Press, 2009-10-08 (Thursday)

[I am including the full text here because
Google News deletes AP stories after a short time.
By the way, so far as I could see
the Washington Post and New York Times essentially ignored this story,
even though it seems to me more significant than what they did cover.
The emphasis is added.]


Federal regulators on Wednesday (2009-10-07) asked a House panel
to strengthen proposed legislation
that would impose new oversight on derivatives,
complex financial instruments
blamed by regulators for hastening the financial crisis.
Republican lawmakers contend the measure already could
eliminate jobs and stifle companies’ ability to manage risks.

A potent new coalition of about 170 companies that use derivatives —
including Boeing Co., Caterpillar Inc., Ford Motor Co.,
General Electric Co. and Shell Oil Co. —
is lobbying Congress to make the case that
legislative proposals to regulate derivatives
could severely increase costs for corporate America.

Companies of all kinds use derivatives to hedge against risks —
airlines ensuring against spikes in fuel prices, for example.
[Yeah, but what about the industrial corporations listed above?]
At the same time,
the complex products have become
a growing vehicle for financial speculation
and ballooned into a $600 trillion global market.

Regulators say they pose a threat to the stability of the financial system.

A splintered committee, with Democrats themselves split, and vigorous lobbying
make it likely the work on the legislation will be lengthy and intense.
The panel has scheduled a drafting session and vote for next week.
Rep. Barney Frank, D-Mass., the committee’s chairman,
stressed that the proposal he put forward is “a work in progress.”
He acknowledged that there may be “gaps” in some areas in the draft as written.

The Obama administration is pressing lawmakers to pass the bill quickly,
along with other broader reforms of the financial regulatory system.

In a private meeting on Capitol Hill on Wednesday,
Treasury Secretary Timothy Geithner told House Democrats,
including Majority Leader Steny Hoyer, D-Md., that
regulating derivatives would reduce risk
and help companies that rely on the financial instruments save money.

The meeting was one of several in recent weeks between senior administration officials and lawmakers.

A final bill isn’t likely to clear Congress
and land on President Barack Obama’s desk
until December at the earliest, Frank said.
It is considered to be less stringent
than the administration’s proposal for new oversight on derivatives,
which are traded in an unregulated global market.

Frank’s proposal is an improvement over the administration plan
but still includes “potentially troublesome” requirements,
said Rep. Spencer Bachus of Alabama, the committee’s senior Republican.
By creating a new category called “major swap participants,”
subject to rules for holding capital against risk,
the proposal could force thousands of companies
to draw capital away from new investment
to use as the required collateral,
Bachus said.

“It seems counterintuitive during a recession,
with unemployment approaching 10 percent,
to leave companies exposed to greater risk,
raise their cost of capital,
and make economic recovery more difficult to achieve,” he said.

But Frank’s fellow Democrat Mel Watt of North Carolina
said the proposal may not be strict enough,
by creating loopholes that could allow
some big financial firms that deal in credit swaps
to skirt regulations.

The proposals are designed
to bring transparency to, and prevent manipulation in
the sprawling derivatives market.
Credit default swaps, a form of insurance against loan defaults,
account for an estimated $60 trillion of that market.
The collapse of the swaps
brought the downfall of Wall Street banking house
Lehman Brothers Holdings Inc.
and nearly toppled American International Group Inc. last fall,
prompting the government to support the insurance conglomerate
with about $180 billion in aid.

The value of derivatives hinges on an underlying investment or commodity —
such as currency rates, oil futures or interest rates.
The derivative is designed to reduce the risk of loss from the underlying asset.

Gary Gensler, the chairman of the Commodity Futures Trading Commission,
called Frank’s proposal “an important contribution”
toward achieving comprehensive oversight of derivatives
but urged changes “to ensure that
we cover the entire marketplace without exception.”

“The American public needs to benefit from the full transparency”
that would come from mandating
most derivatives go through a new network of clearinghouses
and be traded on regulated exchanges, he said.

[Amen. More transparency into what is being traded and by whom
is absolutely essential for the nation to manage its risk.]

Henry Hu, director of the Securities and Exchange Commission’s
new division of risk, strategy and financial innovation, said
“relatively simple changes to the discussion draft would ensure that
the legislation results in the improved supervision” of the derivatives market.

Unlike Gensler, Hu didn’t advocate mandatory exchange trading of derivatives,
saying the needed transparency
would be provided by the system of clearinghouses.

The big banks that dominate the over-the-counter derivatives market
have committed to targets in expanded central clearing systems
in a voluntary program.

While more than 1,000 U.S. banks trade derivatives, five big institutions —
JPMorgan Chase & Co., Goldman Sachs Group Inc.,
Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. —
account for 97 percent of the total reported to be held by U.S. banks.

The torrent of lobbying over derivatives legislation also has included
the big Wall Street banks, commodities traders and hedge funds.

Who’ll Rein In Wall St.?
By Harold Meyerson
Washington Post, 2009-10-14

The deliberations of the Senate Finance Committee on health-care reform -- which, understandably, have monopolized the public’s attention to Capitol Hill -- have concluded not a moment too soon. On Wednesday the House Financial Services Committee begins the first congressional mark-up of legislation every bit as important: the bills that would rein in Wall Street.

But there’s a problem. Looking at perhaps the single most important bill the committee will consider -- the one that will regulate derivatives, those opaque contracts that brought down Bear Stearns and Lehman Brothers and would have brought down AIG but for $180 billion in taxpayer money -- the banks have nothing to complain about. The regulations don’t amount to much. The peril these derivatives pose to the economy will persist.

Under current practice, these deals, whereby banks and corporations hedge against many kinds of risk, are unregulated. There is no place where these deals are reported, no open exchange on which companies can shop for the best deal available and on which prices and risk become transparent. There is no way to know when major financial players are holding trillions of dollars of paper that cannot be redeemed -- until they are about to go under, dragging the rest of the economy down with them.

The Obama administration has been trying to change all that. Led by Gary Gensler, the chairman of the Commodity Futures Trading Commission, the administration proposed a bill that would have established an exchange on which derivatives, like stocks and bonds, could be traded. “It’s very important to have transparency,” Gensler said Tuesday. “Without it, there’s a very significant information gap” between the sellers and buyers of derivatives, and for regulators trying to gauge the level of systemic risk.

But the five biggest American banks make a lot of money from that information gap. Of the $291 trillion that is the notional value of all such deals held by American banks, fully 95 percent, according to the most recent report from the Office of the Controller of the Currency, was held by J.P. Morgan Chase, Bank of America, Goldman Sachs, Morgan Stanley and Citigroup. In the first six months of this year, those banks made more than $15 billion trading in derivatives. “A natural consequence of improving transparency and information on pricing [which happens on exchanges] is that the intermediaries who dominate the market will see lower profit margins and somewhat lower volumes of transactions,” according to congressional testimony by Rob Johnson, director of the Economic Policy Initiative for the Roosevelt Institute.

Not surprisingly, those intermediaries -- the big banks -- have been fighting like mad to maintain their profits and our risk. So far, they’re succeeding.

The bill that the House Financial Services Committee will take up Wednesday wouldn’t establish an exchange. It would establish a clearinghouse, which is a weaker vehicle for tracking such deals. But it also would allow the banks and their counterparties to avoid posting such deals to the clearinghouse if they didn’t want to, by insisting that their deal wasn’t really standardized to clearinghouse practices. An earlier draft of the bill would even have exempted deals that hedged risk -- and since almost all such deals are created to hedge risk, it would have essentially exempted everyone.

Committee Chairman Barney Frank (D-Mass.) is none too thrilled by the watering-down he has been compelled to accept by the New Democrats -- chiefly Democrats from affluent, suburban swing districts -- on his committee. To his surprise, he said Tuesday, “there was no support for exchanges by community banks and end-users [the companies to which banks sell the derivatives].” Some companies said they feared that the increased margin banks would have to pay might be passed on to them in the form of higher fees. But it’s the banks that the New Democrats, a number of their colleagues allege, are counting on for financial help in next year’s tough reelection battles.

Fortunately, the legislation also has to pass the House Agriculture Committee, which is more likely to include a requirement that deals be conducted on an exchange, or at least that banks and companies report their deals to a clearinghouse. “As things stand now, I’d be more inclined to support the Ag bill,” says Frank.

Notwithstanding the New Democrats, tougher regulations are not only good for the economy, they’re good for the Democratic Party. If Democrats fail to rein in Wall Street’s riskiest practices, says one unorthodox Democratic financier, “there’s a real possibility that the Democrats will be answerable for Catastrophe Round Two. If the stock market pops again, placing major strains on banks that have been engaging in these very risky practices, the evidence trail this time will lead straight to the Democrats.”

Lobbyists Mass to Try to Shape Financial Reform
New York Times, 2009-10-15

Key House Panel Votes to Regulate Derivatives
New York Times, 2009-10-16

The State of Financial Reform
New York Times Editorial, 2009-10-25

[Here is the third of the editorial that I think is most significant.]

Too Little Regulation for Derivatives

The Obama administration and Congress have vowed to regulate derivatives,
the complex and often highly speculative financial instruments
that were at the heart of the meltdown.
Two House committees have approved legislation, but —
after heavy lobbying from the banking industry and corporate America —
both versions are weak and unlikely to prevent another fiasco.

Right now,
many derivative deals are executed as private one-on-one contracts,
outside the view of the public or regulators.
This lack of transparency — about participants, prices and volumes —
proved disastrous.
In the bailout of American International Group,
tens of billions of taxpayer dollars went to pay the world’s biggest banks
for derivative bets gone spectacularly wrong.

The bills require that many derivatives be traded on public exchanges,
but then carve out far too many exceptions.
One huge loophole would exempt derivatives from exchange trading
for corporations that use them to hedge operational risks,
say, an airline that wants to lock in fuel prices.
The supposed logic is that corporate derivative users did not cause the crisis.

But such derivatives make up a big chunk of the $592 trillion industry.
If they are exempted,
potentially trillions of dollars worth of transactions
could avoid the exposure — and stability — that comes with exchange trading.
Even worse, under the current wording,
this exemption could be read to apply to many more companies,
including hedge funds and other investor groups.

The stated aim of the exemption is to keep transaction costs low
when corporations use derivatives to hedge their various risks.
But there is no compelling evidence that exchange trading will drive up costs.
And even if the cost were to rise somewhat,
transparency is a more important goal.

if John Q. Public can be charged a fee for supporting the New York Stock Exchange
when he buys stock listed on it,
then I think corporations can pay a fee for their derivative transactions.
We all know that if things blow up (as they surely will)
Uncle Sam will be asked to clean up the mess.
They have no right to not shed some light on
the problems that the taxpayer may later be liable for.]

The bill approved by the Financial Services Committee
has an additional weakness:
it denies regulators powers they need to fully police the market.
For instance,
they would not have the authority
to ban dangerous products and abusive practices.
Bans are a heavy-handed tool.
But the ability to impose bans on toxic instruments
should be part of the tool kit.

Both versions must be improved, on the House floor and in the Senate.
In a sign of what we hope will be tough battles ahead,
Senator Maria Cantwell, Democrat of Washington
and a member of the Finance Committee,
has written to Treasury Secretary Timothy Geithner,
asking him to explain the administration’s support
for the flawed bill from the Financial Services Committee.

Insisting on strong derivatives reform is a matter of putting taxpayers first —
ahead of the big banks and corporate America
that are fighting hard for a return to risky business as usual.

[Although I oppose most of the social engineering practives
that the Times typically editorially endorses,
on this matter of regulating risky business practices that put the taxpayer at risk,
I wholeheartedly concur.]

Lessons learnt
By Nouriel Roubini
Financial Times, 2009-10-30

Volcker Criticizes Accounting Proposal
New York Times, 2009-11-17

A proposal to give banking regulators authority to block accounting standards is “a terrible idea,” Paul A. Volcker, a former chairman of the Federal Reserve Board, said Monday.

Mr. Volcker has been an outspoken critic of “mark to market” accounting that forced banks to take large write-downs in asset values, a position cited by banks earlier this year when they persuaded members of the House Financial Services Committee to demand changes in that rule.

But in an interview Monday, two days before a House committee vote on a proposal that would grant bank regulators the power to sidestep accounting standards, Mr. Volcker said he believed that accounting rules had to be set by an independent agency. He voiced concern that rising political pressures on both sides of the Atlantic were endangering that independence.

The Financial Services Committee is to vote on amendments to a bill to establish a council of bank regulators as a systemic risk regulator, able to take action if bank activities threaten financial stability.

The amendment, proposed by Representative Ed Perlmutter, Democrat of Colorado, and strongly supported by the banks, would give that group of regulators the power to order the Securities and Exchange Commission, which now oversees the Financial Accounting Standards Board, to suspend or change any accounting rule that the council thinks is a threat to financial stability.

The amendment has been endorsed by the American Bankers Association, which says the S.E.C.’s focus, on helping investors, is too narrow. The amendment has been strongly opposed by groups including the Chamber of Commerce and groups representing investors.

Leslie Oliver, an aide to Representative Perlmutter, said the congressman was still working on final language of the amendment and expected it to be voted on by the committee on Wednesday.

The bankers’ group contends it is clear that accounting standards worsened the crisis, while others argue that the accounting rules belatedly forced the banks, and their regulators, to report on the disastrous results caused by their previous errors.


Whose side is Obama on?
By Steven Pearlstein
Washington Post, 2009-11-25 (Wednesday)

There is much to be thankful for this holiday,
including the fact that we live in a country
that has been remarkably good-natured, generous and pragmatic
in the face of a nasty economic crisis.
The rates of unemployment and under-employment have already hit
a combined 17 percent.
Household wealth has been significantly diminished.
Reluctantly, we agreed to take on more public debt
to finance a massive bailout of a financial sector that badly let us down.
We stepped up our household savings and embraced the new frugality.

What really sticks in our craw, however, is that
while most of the country is hunkered down,
Wall Street continues to feast on a bounty of trading profits.
You’d expect that a new liberal Democratic president
would find a way to give voice to this populist outrage and
constructively channel this public anger.
But too often,
the response from the administration has been to try to convince us that
there’s little we can do, or should do,
to ensure that the economic harvest is more equitably distributed.
Now, the White House and congressional leaders find themselves scrambling
to get ahead of a growing political backlash
that threatens to upend their carefully calibrated agenda,
not to mention their political fortunes.

Fairly or unfairly,
the official who has come to personify this let-them-eat-stuffing attitude is Treasury Secretary Tim Geithner,
who can’t seem to decide whose side of the buffet table he’s really on.
It was Geithner who, at the height of the financial crisis last year,
was able to best articulate the unpleasant truth that
we could save the financial system or
we could punish the banks
but we couldn’t do both at the same time.
But now that the system has been saved,
he seems to have lost his appetite for retribution.

A telling moment came
at the meeting of finance ministers in St. Andrews, Scotland, earlier this month,
when Geithner gave a back-of-the-hand to the idea of

a global tax on financial transactions [q.v.; cf. the “Tobin tax”]
as a way of raising money for economic stabilization
while also discouraging high-volume, short-term speculation.

In the past,
the problem with this idea was that
if any country imposed such a tax,
trading would simply move somewhere else.
with most industrial countries now willing to act in concert,
a transaction tax could have been a viable option --
until, that is, Geithner dismissed it as
a desperate political gambit by an unpopular British prime minister
and vowed that the United States would never go along.

By itself, perhaps, the incident could have been written off as
a difference of opinion about means rather than ends.
But it seemed to be of a piece with
Geithner’s determination to avoid upsetting markets
or upending the Wall Street order.

This was the same Geithner, after all, who has pushed
not only to preserve but expand the powers of a Federal Reserve
that had been the regulatory hand-maiden of
Wall Street banks and investment houses.

It was Geithner and the Treasury that
proposed to enshrine the doctrine of “too big to fail” into law,
rejecting calls to break up the biggest banks and
designating certain institutions for this special status.
Treasury also opposed language that
would have required creditors and counterparties of these institutions
to take losses
if some form of government receivership were required.

And it has been Geithner who,
for all his talk about reforming the structure of Wall Street pay,
has never been able to bring himself to declare the simple truth that
Wall Street pay is absurdly high.

It’s fair to say that
Geithner’s credibility has been so tarnished
in the eyes of Congress and the public that
President Obama will now have to devote
more personal attention to these issues.

Obama could start by
instructing the Justice Department to launch an antitrust inquiry
to determine
why Wall Street continues to earn
the extravagant profits from which the bonuses are derived.

The president could press Congress to close the tax loophole
[carried interest]
that allows managers of hedge funds and private-equity funds
to pay lower tax rates than their secretaries.
He could ask the country’s largest pension plans, mutual funds and endowments
to come up with voluntary pay standards for their own managers and traders,
but also for any banks or money managers they do business with.

And Obama could ask the Group of 20 to
put the transaction tax back on the agenda,
and vow to use the $50 billion a year in revenue that it would generate here
to finance the much-needed transportation infrastructure improvements
that the president himself has proposed.

I’m all for funding
the American infrastructure that has been sadly and shamefully neglected
due to the American emphasis on healthcare,
but let’s reduce the deficit first.]

In truth,
none of this will create the jobs the country now desperately needs.
But governing is as much about symbolism as it is about substance.
Only by taking steps to assure the nation that
the economy will no longer be rigged in Wall Street’s favor
can the president regain the political high ground
and push through a new jobs agenda.

Keeping Derivatives in the Dark
New York Times, 2009-11-27

Opaque markets breed insider profits and abuse of investors.
Sunshine can bring competition and lower costs
even if regulators do little beyond letting the sunlight shine.

You might think that as Congress considers
just how much regulation is needed for the shadow financial system
the one that largely escaped regulation in the past —
letting in such light would be an easy and uncontroversial move.

But it is not proving to be easy at all,
and is one part of the Obama administration’s financial reform package
that is most in jeopardy.

Timothy Geithner, the secretary of the Treasury,
will testify before the Senate Agriculture Committee next week
in an effort to hold on to
important provisions of the proposal that have come under attack
by banks fearful of losing one of their most profitable franchises —
the selling of customized derivatives to corporate customers.

the banks have persuaded customers that
keeping the market for those products secret
is in their interest.

Last week, Gary Gensler,
the chairman of the Commodities Futures Trading Commission,
faced the same panel,
and ran into questions that indicated
at least some senators were sympathetic to efforts to
keep large parts of the derivatives market in the dark.

Those markets allow companies to bet on —
or, if you prefer, hedge themselves against losses from —
changing interest rates and commodity prices.
They also allow investors to use credit-default swaps
to bet on whether a company will go broke.
The administration wants to standardize those products when possible,
and force the trading of them onto exchanges when possible.

Banks want to whittle away the reforms if they can,
and to minimize the roles of
the C.F.T.C. and the Securities and Exchange Commission,
experienced market regulators
who have been generally kept away from over-the-counter derivatives
in the past.
the banks would like to leave it to banking regulators to oversee the dealers,
something regulators totally failed to do in the past.
Unless Mr. Geithner can persuade legislators otherwise,
one of the great bank lobbying campaigns will have succeeded,
in large part because
some companies that buy derivatives from banks
have been persuaded that
their costs will rise if needed reforms were made.

The opposite is probably true.
The history of nearly all markets is that customers suffer
if dealers are able to keep them ignorant of what is actually going on.

Until the beginning of this decade,
that was true in the corporate bond market,
where actual trades were kept confidential.
That made it easy for bond dealers to charge big markups
when they sold bonds to customers.

After regulators forced timely disclosures, the bid-ask spreads —
the difference between what customers paid when they bought bonds
and what they could get when selling them —
declined significantly.
The result was smaller profits for bond dealers,
and better returns for bond investors.

“It is now time,” Mr. Gensler testified,
“to promote similar transparency in the relatively new marketplace”
for derivatives traded over the counter.

“Lack of regulation in these markets,” he added,
“has created significant information deficits.”

He listed
“information deficits for market participants
who cannot observe transactions as they occur and, thus,
cannot benefit from
the transparent price discovery function of the marketplace;
information deficits for the public
who cannot see the aggregate scope and scale of the markets; and
information deficits for regulators who cannot see and police the markets.”

In the listed markets for derivative securities, like futures,
there are margins that must be posted every day
if markets move against the buyer of the derivative.
Corporate customers of over-the-counter derivatives fear that
they might face similar margin requirements
if their contracts were to be traded on exchanges,

and have persuaded some legislators that would be horrible.

Of course, because prices aren’t made public,
we can only hope [charming]
that the banks currently are pricing the credit at reasonable levels.
The banks say they are. [??]
Robert Pickel, the chief executive of
the International Swaps and Derivatives Association, an industry group,
assured me this week that
“the cost of credit is taken into account
in the collateral relationship and in the bid-ask spread.”

In layman’s terms, that means that customers with worse credit
would face different prices than customers with excellent credit,
which Mr. Pickel argued would make price disclosure of limited value.

Mr. Gensler, the C.F.T.C. chairman,
argues that customers would be better off if the two markets —
for the derivatives and for the credit —
were separated and had clear pricing.
“How else,” he asked in an interview,
“can customers know if they are getting fair prices?”

Remarkably, big corporations like Boeing, Caterpillar and many others
that use derivatives to hedge risk
have been persuaded by bankers that they should not worry about that.

If over-the-counter derivatives were to be traded on exchanges,
or centrally cleared, or subject to margin requirements,
a host of corporate trade associations and companies
said in a recent letter to legislators,
such reforms “would inhibit companies
from using these important risk management tools
in the course of everyday business operations.
These proposals, which would increase business risk and raise costs,
are at cross purposes with the goals of
lowering systemic risk and promoting economic recovery.”

Reflected in that letter is a belief that the banks,
in designing and selling derivatives to customers,
are acting as trusted advisers,
looking out for the best interests of their customers.
Every so often, one of these deals blows up and winds up in court.
Then the banks argue that they were simply counterparties,
with no responsibility for the wisdom, or lack of same,
shown by the customers.

If, as seems likely,
Congress chooses to eliminate or minimize the disclosure of customer trades,
and if it allows custom derivatives to remain almost completely opaque
and without visible pricing of credit,
that will encourage some corporate customers
to prefer customized contracts.
Such contracts will probably cost them more,
but the cost of credit will be hidden,
and they may not have to post collateral immediately
if they are losing money.

For Mr. Geithner, this legislative battle may indicate
whether he still has the ability to persuade legislators,
or whether he has become the political liability
that at least some Republicans think he is.
When he ventured to Capitol Hill earlier this month,
one congressman suggested he should resign.

If Mr. Geithner is vulnerable, it is because
the efforts of the administration and the Federal Reserve
to save the banking system worked too well.
The fears of collapse that were present early this year have faded away,
and been replaced by a general feeling of resentment.

The banks seem to be on the verge of harnessing that feeling of resentment
to preserve a major profit center.
In terms of lobbying, it will be a remarkable achievement.

Debt Raters Avoid Overhaul After Crisis
New York Times, 2009-12-08

When the financial crisis began,
few players on Wall Street looked more ripe for reform
than the Big Three credit rating agencies.

It wasn’t just that
Moody’s Investors Service, Standard & Poor’s and Fitch Ratings,
played a crucial role in the epochal housing market collapse,
affixing their most laudatory grades to billions of dollars worth of bonds
that went bad in the subprime crisis.

It was the near universal agreement that
potential conflicts were embedded in the ratings model.
For years, banks and other issuers
have paid rating agencies to appraise securities —
a bit like a restaurant paying a critic to review its food,
and only if the verdict is highly favorable.

So as Washington rewrites the rules of Wall Street,
how is the overhaul of the Big Three coming?
It isn’t, finance experts say.

“What you see in these bills are Botox shots,”
says Joseph A. Grundfest, a professor of securities law at Stanford Law School.
“For a little while, everyone is going to be frozen into a grin,
and then the shots are going to wear off.”

What explains the timidity of Congress’ proposals?
This is not a case of lobbyists beating back
ideas that might hurt their clients,
say those close to the discussions.
Instead, Congress is worried that bold measures may backfire.
The Big Three,
by allowing companies and public entities to raise money by issuing debt,
are an essential engine in the country’s vast credit factory,
and given the still-fragile condition of the equipment,
lawmakers are reluctant to try anything but
basic repairs, patches and a new alarm system.

In addition, legislators say, there is little consensus about
what a top-to-bottom renovation should look like.

Under bills that legislators are currently considering,
the rating agencies will have to contend with greater oversight,
stiffer rules about disclosure and
a provision that would make it easier for plaintiffs to sue the firms.
nothing in the laws tackles the critic-for-hire problem
or threatens the 85 percent market share
that Moody’s, S.& P. and Fitch now enjoy.



A Bomb Squad for Wall Street
New York Times Opinionator Blog, 2010-01-21

[T]oday we are going to discuss
the highly opaque but hugely important topic of “O.T.C. derivatives,”
or securities that derive their value from other securities
and are traded between institutions “over-the-counter,”
rather than on an exchange
where they can be more closely regulated and monitored.


[T]he ongoing failure
to monitor the trading of derivatives on a formal exchange —
as most stocks and bonds are —
was one of the major, albeit least understood, factors
contributing to today’s economic mess.
The problem was that

valuing these securities became nearly impossible,
and yet
so much depended on that valuation.


British Central Banker Favors Splitting Big Banks
New York Times, 2010-01-27

[Mervyn A. King, the governor of the Bank of England,]
finds himself at the vanguard of a growing movement that argues that
big banks must separate
their higher-risk trading and investment banking businesses
from their core deposit-taking functions.


How to Reform Our Financial System
New York Times Op-Ed, 2010-01-31

PRESIDENT OBAMA 10 days ago set out one important element
in the needed structural reform of the financial system.
No one can reasonably contest the need for such reform,
in the United States and in other countries as well.
We have after all
a system that broke down in the most serious crisis in 75 years.
The cost has been enormous in terms of unemployment and lost production.
[Not to mention the investment dollars that vaporized.]
The repercussions have been international.

Aggressive action by governments and central banks —
really unprecedented in both magnitude and scope —
has been necessary to revive and maintain market functions.
Some of that support has continued to this day.
Here in the United States as elsewhere,
some of the largest and proudest financial institutions —
including both investment and commercial banks —
have been rescued or merged with the help of massive official funds.
Those actions were taken out of well-justified concern that
their outright failure would irreparably impair market functioning
and further damage the real economy already in recession.

Now the economy is recovering, if at a still modest pace.
Funds are flowing more readily in financial markets, but still far from normally.
Discussion is underway here and abroad about specific reforms,
many of which have been set out by the United States administration:
appropriate capital and liquidity requirements for banks;
better official supervision on the one hand and on the other
improved risk management and board oversight for private institutions;
a review of accounting approaches toward financial institutions;
and others.

As President Obama has emphasized,
some central structural issues have not yet been satisfactorily addressed.

A large concern is the residue of moral hazard
from the extensive and successful efforts of central banks and governments
to rescue large failing and potentially failing financial institutions.
The long-established “safety net”
undergirding the stability of commercial banks —
deposit insurance and lender of last resort facilities —
has been both reinforced and extended
in a series of ad hoc decisions to support
investment banks, mortgage providers
and the world’s largest insurance company.
In the process,
managements, creditors and to some extent stockholders of these non-banks
have been protected.

The phrase “too big to fail” has entered into our everyday vocabulary.
It carries the implication that
really large, complex and highly interconnected financial institutions
can count on public support at critical times.

The sense of public outrage over seemingly unfair treatment is palpable.
Beyond the emotion, the result is
to provide those institutions with a competitive advantage
in their financing, in their size
and in their ability to take and absorb risks.

As things stand,
the consequence will be
to enhance incentives to risk-taking and leverage,
with the implication of an even more fragile financial system.
We need to find more effective fail-safe arrangements.

In approaching that challenge, we need to recognize that
the basic operations of commercial banks are integral to
a well-functioning private financial system.
It is those institutions, after all,
that manage and protect the basic payments systems upon which we all depend.
More broadly, they provide the essential intermediating function
of matching the need for
safe and readily available depositories for liquid funds
with the need for
reliable sources of credit for businesses, individuals and governments.

Combining those essential functions unavoidably entails risk,
sometimes substantial risk.
That is why Adam Smith more than 200 years ago
advocated keeping banks small.
Then an individual failure would not be so destructive for the economy.
That approach does not really seem feasible in today’s world,
not given the size of businesses,
the substantial investment required in technology
and the national and international reach required.

Instead, governments have long provided commercial banks
with the public “safety net.”
The implied moral hazard has been balanced by
close regulation and supervision.
Improved capital requirements and leverage restrictions
are now also under consideration in international forums
as a key element of reform.

The further proposal set out by the president recently
to limit the proprietary activities of banks
approaches the problem from a complementary direction.
The point of departure is that
adding further layers of risk
to the inherent risks of essential commercial bank functions
doesn’t make sense,
not when those risks arise from more speculative activities
far better suited for other areas of the financial markets.

The specific points at issue are
ownership or sponsorship of hedge funds and private equity funds,
and proprietary trading — that is,
placing bank capital at risk in the search of speculative profit
rather than in response to customer needs.

Those activities are actively engaged in
by only a handful of American mega-commercial banks, perhaps four or five.
Only 25 or 30 may be significant internationally.

Apart from the risks inherent in these activities,
they also present
virtually insolvable conflicts of interest with customer relationships,
conflicts that simply cannot be escaped
by an elaboration of so-called Chinese walls
between different divisions of an institution.
The further point is that the three activities at issue —
which in themselves are legitimate and useful parts of our capital markets —
are in no way dependent on commercial banks’ ownership.
These days there are literally thousands
of independent hedge funds and equity funds of widely varying size
perfectly capable of maintaining innovative competitive markets.
such independent capital market institutions, typically financed privately,
are heavily dependent like other businesses upon commercial bank services,
including in their case prime brokerage.
Commercial bank ownership only tilts a “level playing field”
without clear value added.

Very few of those capital market institutions,
both because of their typically more limited size
and more stable sources of finance,
could present a credible claim to be “too big” or “too interconnected” to fail.
In fact,
sizable numbers of such institutions fail or voluntarily cease business
in troubled times with no adverse consequences for the viability of markets.

What we do need is protection against the outliers.
There are a limited number of investment banks
(or perhaps insurance companies or other firms)
the failure of which would be so disturbing
as to raise concern about a broader market disruption.
In such cases,
authority by a relevant supervisory agency to limit their capital and leverage
would be important, as the president has proposed.

To meet the possibility that failure of such institutions
may nonetheless threaten the system,
the reform proposals of the Obama administration and other governments
point to the need for a new “resolution authority.”
the appropriately designated agency should be authorized to intervene
in the event that
a systemically critical capital market institution
is on the brink of failure.
The agency would assume control
for the sole purpose of arranging an orderly liquidation or merger.
Limited funds would be made available to maintain continuity of operations
while preparing for the demise of the organization.

To help facilitate that process, the concept of a “living will”
has been set forth by a number of governments.
Stockholders and management would not be protected.
Creditors would be at risk, and would suffer to the extent that
the ultimate liquidation value of the firm would fall short of its debts.

To put it simply, in no sense would these capital market institutions
be deemed “too big to fail.”
What they would be free to do
is to innovate, to trade, to speculate, to manage private pools of capital —
and as ordinary businesses in a capitalist economy, to fail.

I do not deal here with other key issues of structural reform.
effective arrangements for clearing and settlement and other restrictions
in the now enormous market for derivatives
should be agreed to as part of the present reform program.
So should the need for a designated agency — preferably the Federal Reserve —
charged with reviewing and appraising market developments,
identifying sources of weakness
and recommending action to deal with the emerging problems.
Those and other matters are part of the administration’s program
and now under international consideration.

[You know, that sounds good in theory,
but all such regulatory systems are only as good as
the people staffing and managing them.
Take, for example,
Alan Greenspan,
who failed to see that the housing bubble was indeed a bubble,
the popping of which would cause enormous damage to
all those investors who had bought high and now would have to sell low,
and Ben Bernanke, who in January 2010 made the absurd claim that
“only a small portion of the increase in house prices earlier this decade
can be attributed to the stance of U.S. monetary policy”.
When Fed chairman are so lacking in insight, how can we depend on the Fed?]

In this country,
I believe regulation of large insurance companies operating over many states
needs to be reviewed.
We also face a large challenge in rebuilding
an efficient, competitive private mortgage market,
an area in which commercial bank participation is needed.
Those are matters for another day.

What is essential now is that
we work with other nations hosting large financial markets
to reach a broad consensus on an outline for the needed structural reforms,
certainly including those that the president has recently set out.
My clear sense is that relevant international and foreign authorities
are prepared to engage in that effort.
In the process,
significant points of operational detail will need to be resolved,
including clarifying
the range of trading activity appropriate for commercial banks
in support of customer relationships.

I am well aware that there are interested parties
that long to return to “business as usual,”
even while retaining the comfort of remaining within
the confines of the official safety net.
They will argue that
they themselves and intelligent regulators and supervisors,
armed with recent experience,
can maintain the needed surveillance,
foresee the dangers
and manage the risks.

In contrast, I tell you that is no substitute for structural change,
the point the president himself has set out so strongly.

I’ve been there —
as regulator, as central banker, as commercial bank official and director —
for almost 60 years.
I have observed how memories dim. Individuals change.
Institutional and political pressures to “lay off” tough regulation will remain —
most notably in the fair weather that inevitably precedes the storm.

The implication is clear.
We need to face up to needed structural changes, and place them into law.
To do less will simply mean ultimate failure —
failure to accept responsibility for learning from the lessons of the past
and anticipating the needs of the future.

Paul Volcker, a former chairman of the Federal Reserve,
is the chairman of the president’s Economic Recovery Advisory Board.

A.I.G., Greece, and Who’s Next?
New York Times Editorial, 2010-03-04

As Greece has tottered on the brink of fiscal chaos, threatening to drag much of Europe down with it, Wall Street’s role in the fiasco has drawn well-deserved scorn.

First came the news that Greece had entered into derivatives transactions with Goldman Sachs and other banks to hide its public debt. Then came reports that some of those same banks and various hedge funds were using credit default swaps — the type of derivative that kneecapped the American International Group — to bet on the likelihood of a Greek default and using derivatives to wager on a drop in the euro.

European leaders have called for an inquiry into the Greek crisis. Ben Bernanke, the Federal Reserve chairman, has told Congress that the Fed is “looking into” Wall Street’s deals with Greece, and the Justice Department is investigating the euro bets. That is better than turning a blind eye, but it is not nearly enough.

The bigger problem is in America, where markets are supposed to be fair and transparent. These particular — and particularly complicated — instruments are traded privately among banks, their clients and other investors with virtually no regulation or oversight.

The Obama administration and Congress have been talking for a year about fixing the derivatives market. Big banks have been lobbying to block change. And the longer it takes, the weaker the proposed new rules become.

Here are some of the problems that must be fixed:

NO TRANSPARENCY Derivatives are supposed to reduce and spread risk. In a credit default swap, for instance, a bond investor pays a fee to a counterparty, usually a bank, that agrees to pay the investor if the bond defaults. But because the markets in which they trade are largely unregulated, derivatives can too easily become tools for dangerous risk-taking, vast speculation and dodgy accounting.

A big part of the problem is that derivatives are traded as private one-on-one contracts. That means big profits for banks since clients can’t compare offerings. Private markets also lack the rules that prevail in regulated markets — like capital requirements, record keeping and disclosure — that are essential for regulators and investors to monitor and control risk.

That is why it is so essential to move derivative trades onto fully transparent exchanges. The administration originally embraced that idea, with exceptions only for occasional, unique contracts. But when the Treasury proposed legislation in August, it included huge loopholes, and a derivative reform bill that passed the House in December has many of the same problems. (The Senate has yet to introduce a reform bill.)

Both the administration and the House would exclude from exchange trading the estimated $50 trillion market in foreign exchange swaps — similar to the derivatives Greece used to hide its debt. The rationale for the exclusion never has been clearly explained.

The Treasury proposal and House bill also would exclude transactions that occur between big banks and many of their corporate clients from the exchange trading requirement, ostensibly because those deals are only for minimizing business risks, not for speculation or for window-dressing the books. That’s debatable. But even if true, other derivatives users would almost inevitably find ways to exploit such a broad exemption.

What is clear about the exemptions is that they would help to preserve banks’ profits. What is also clear is that they would defeat the goals of reform: to lower risk, increase transparency and foster efficiency.

LIMITED POWER TO STOP ABUSES When the House put out a draft of new rules in October, it sensibly gave regulators the power to ban abusive derivatives — ones that are not necessarily fraudulent, but potentially damaging to the system. Derivatives investors who stand to make huge profits if a company or country defaults, for example, might try to provoke default — a situation that regulators should be able to prevent. In the final House bill, however, the ban was replaced with a requirement that regulators simply report to Congress if they believe abuses are occurring.

NO STATE REGULATION, EITHER Current law also exempts unregulated derivatives from state antigambling laws. That means that states have no power to police their use for excessive speculation. Treasury and House reform proposals have called for maintaining the federal pre-emption of state antigambling laws. Pre-emption could be tolerable if derivatives were traded on fully regulated exchanges. But as long as many derivative products and transactions are exempted from fully regulated exchange trading, pre-emption of state antigambling laws is a license for, well, gambling.

The big banks claim that derivatives are used to hedge risk, not for excessive speculation. The best way to monitor that claim is to execute the transactions on fully regulated exchanges, pass rules and laws to ensure stability, and appoint and empower regulators with independence and good judgment to enforce compliance.

Without effective reform, the derivative-driven financial crisis in the United States that exploded in 2008, and the Greek debt crisis, circa 2010, will be mere way stations on the road to greater calamities.

Behind Consumer Agency Idea, a Tireless Advocate
New York Times, 2010-03-25

Congress fulfills narrow ambitions with financial overhaul bill
By Allan Sloan
Washington Post, 2010-06-29

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