Posted by Karl Denninger
In the report, the panel, that includes Rob Johnson of the United Nations Commission of Experts on Finance and bailout watchdog Elizabeth Warren, warns that financial regulatory reform measures proposed by the Obama administration and Congress must be beefed up to prevent banks from continuing to engage in high risk investing that precipitated the near collapse of the U.S. economy in 2008.
The report warns that the country is now immersed in a “doomsday cycle” wherein banks use borrowed money to take massive risks in an attempt to pay big dividends to shareholders and big bonuses to management – and when the risks go wrong, the banks receive taxpayer bailouts from the government.
The crisis of 2008 was predictable. Unless we go far beyond current legislative proposals the next crisis is inevitable.
146 pages of rather dry reading, but worth it.
I have only one argument with the paper’s base premise, and that lies here:
This cycle will not run forever. One day soon, we’ll have the boom and bust phases, but when we try the usual bailouts, they won’t work. The destructive power of the down-cycle will overwhelm the restorative ability of the government, just like it did in 1929-31, when both the financial shock and the government capacity to respond were on a much smaller scale. The result, presumably, will be something that looks and feels very much like a Second Great Depression.
The error is in thinking that the “restorative power” of government has worked this time.
It has not. Instead of being a restorative power, it has instead been simple hiding of the facts – or, if you prefer a more-simple word for it, lies.
We have hidden, rather than fixing, balance-sheet deterioration. We are permitting insolvent financial institutions to continue to operate in the belief that they can “earn their way out of the hole” over time, effectively imposing a monstrous (more than $1 trillion annually, or 7% of GDP) tax on the economy. Then we have imposed another 9% tax on the economy in the form of government borrowing to paper over the lack of final demand.
Taken together, this is a 16%-of-GDP tax addition to the tax burden already imposed, and there is no evidence that it will abate.
The report talks of raising capital requirements to somewhere between 15-25% of assets for financial institutions. But that’s a chimera too – not all assets are the same. As I wrote in my piece of November 13th of last year, there is a much simpler way to compute capital requirements that is not subject to regulatory arbitrage or games: do not permit institutions to make any loan that is unsecured unless the unsecured portion of that loan is backed, dollar for dollar, by a dollar of actual capital.
Regulatory arbitrage is better thought of as bribery. The solution to eliminating bribery is to eliminate all the places where one can stuff a pile of cow dung under the carpet. If the decaying fish is on the kitchen table for all to see, and the stench cannot be concealed, then it becomes extremely difficult to buy people off.
This means an end to all credit derivatives that are not exchange-traded (not “registered”), so that nightly mark-to-market accounting is enforced by a real party at interest – the exchange which has to make good on them. It means an end to “naked shorting” in all of its forms. It means an end to the creation of synthetic instruments unless the person you sell them to receives a prospectus disclosing why and how that derivative came into existence – and at who’s behest it happened.
At the core of this problem, along with essentially every banking crisis in the past, is a refusal to speak publicly about the truth of financial institutions: they provide no actual constructive contribution to GDP.
That is, they produce nothing.
Financial intermediation – when it works properly – is by definition a function of matching buyers and sellers of money. That is, by definition it is a parasitic function that draws its “income” off the transactional stream of commerce.
But a parasite is only “successful” if it is able to remain healthy without significantly impairing its host. The most-obvious violation of this principle, of course, is a parasite that kills its host – that organism has failed in its essential purpose if it fails to reproduce before the host dies.
In terms of economic systems failure is more graduated. Certainly a financial system that kills the underlying economy has failed in its essential purpose. But one that imposes regressive and ridiculous effective tax rates – even when not called a tax – has taken the intermediation function and turned it into a death-spiral of vampirism.
Such is the system we have today. Banks are considered an economic force in their own right – not because they add something to GDP (they’re incapable of doing so) but because they are able to control the rise, fall, birth and death of others. The financial intermediation function has become an end in of itself, instead of being a necessary piece of “lubrication” for commerce to proceed. This in turn has led to ridiculous and even outrageous acts, such as the SEC Complaint alleges occurred in Jefferson County, Alabama:
Charles LeCroy and Douglas MacFaddin, the two former managing directors, privately agreed with certain County commissioners to pay more than $8.2 million in 2002 and 20)3 to close friends of the commissioners who either owned or worked at local broker-dealers.
3. Although labeled as payments for work on the transactions, their true purpose was to ensure that County officials selected the broker-dealer, J.P. Morgan Securities Inc., as County bond underwriter, and the bank, JPMorgan Chase Bank, N.A., as County swap provider.
The common word for what is alleged, my friends, is bribe.
Yet when these sorts of things are uncovered the government, in an attempt to “not upset the apple cart” of the vampiric Wall Street mechanism, sues – instead of prosecuting! As with most of these suits this one will likely to be settled with a fine, where if you or I engaged in the same sort of corrupt practice alleged here we’d be sitting behind a set of bars for a decade or more.
The solution to these problems is not found in incrementalism. Rather, it is found in formal and legal recognition of the essential purpose of financial entities – and enforcing the boundaries of same.
In short, financial institutions are intermediaries. Their purpose and function thus inherently must come with fiduciary duty, since without that duty they have no purpose in the economy at all.
Breaches of that duty must be dealt with through harsh sanction, as the essence of their purpose and action cannot inherently come from a desire to profit, but rather their purpose is to help others profit through productive enterprise.
Viewed in this context there is nothing difficult about regulation of these entities.
They must be forced to hold one dollar of capital against each dollar of unsecured lending that is outstanding, no matter to who or on what terms.
They must be held to a fiduciary duty of care with all of their clients, irrespective of which “side” of a transaction they, or their client, happens to be on.
This inherently bars all proprietary trading activities by these institutions since doing so is an inherent and inseparable violation of that fiduciary responsibility toward the persons whom they serve. It cannot be otherwise.
Incidents of bribery, blackmail and dishonesty – irrespective of the form it comes in – must be dealt with both quickly and severely, since all such acts inherently damage the very persons who they have that fiduciary duty toward.
If we had taken this approach to financial entities there would have been no ENRON, no LTCM, no Internet Bubble, no Housing Bubble, no Greece, no AIG, no Lehman and no Bear Stearns Hedge Funds.
All of the financial crises since the 1980s – each and every one of them – would not have happened.
The answers to the problems are simple, if we choose to open our eyes and consider the only actual function that financial entities perform in our economic picture.
If you’re wondering why employment is not rebounding, why The Federal Reserve’s own data shows collapsing government tax revenues along with final demand in the toilet while spending is skyrocketing, you need only look at the financial system’s vampiric behavior and our government’s refusal to deal with those acts as they should for the answer.
For as long as we fail in this regard we will condemn ourselves to an ever-increasing “duty” or “tax” that is diverted by these institutions. This is an inherently unstable configuration and, as the financial system’s effective tax rate is now reaching toward 40% of the economy as a whole (including the inputed taxes from bailouts and handouts) we are rapidly moving toward the “over-center” point (50%) where the cycle becomes self-reinforcing – and collapse becomes inevitable.
The time to do the right thing has basically run out.