Fact and Fiction Behind Too Big to Fail
President Obama will make one of the most important decisions of his second administration when he nominates the next Fed Chairman. Election politics are the norm, but does the fate of the nation recede into the background as Larry Summers’ star rises? Is President Obama more comfortable with Treasury officials who helped build the financial bubble? Where are the hope and change that President Obama promised? Mr. Summers is exceedingly status quo, with an unfortunate history.
This decision is just as much about President Obama as it is about Mr. Summers. Why should a Sarbanes-Oxley level of responsibility for what transpires within a corporation not also be the standard for a President with regard to his administration? It’s time to debunk a myth about how the financial bubble was built and to look at Mr. Summers in action. When the nation is at a stalemate between its elite and its ordinary citizens, why appoint someone who will only promote paralysis?
The National Face-Off
The nation is paralyzed in a face-off between a politically-favored elite and hundreds of millions of ordinary citizens. The former are the elite of Wall Street, who dominate Washington politics, the financial services industry and therefore the global economy. The latter are just about everybody else — those who rely upon Social Security, Medicare and other government entitlements.
Most citizens aren’t part of the truly elite or the truly poor. Call them the Stuck-in-the-Middle class. Stuck between the choice of an Obama and a Romney, for example. They’d like pragmatic and also fair solutions, but find themselves caught between two highly-polarized parties preying on their emotions.
The dollar knows no race, gender, religion or economic class. The nation’s borrowing capacity supports every citizen from the elite to the poor. All our futures ride on their success or failure.
This nomination is ultimately about democracy. Americans watch Op-Ed wars over stimulus versus austerity. Nobody on the stimulus side mentions that stimulus involves borrowing the money to spend. It worked well since the 1930s, but in 1930 the Federal debt in current dollars was about $1,300 per person. It is now over $38,000 per person and continues to grow as long as we have an annual deficit. Each U.S. citizen including infants must pay the interest and principal on that Federal debt, or we won’t be able to borrow more money. On top of supporting the Federal debt, families must also support state and local debt, college loans, mortgage loans, car loans, other taxes and normal family expenditures.
Federal debt rose in the past during wars. But something is different this time. Wars ended and war spending ceased. Debt was paid down. Today the borrowing finances entitlement spending, which will continue to grow as the Baby Boomers age. While some argue about who is pushing Grandma under the bus, they don’t see the Mack truck of financial crisis coming from the other direction. How difficult it is to have needed infrastructure spending compete with entitlement spending. Will the bus safely cross the deteriorating bridge?
The reality behind these numbers is sinking in. The book and documentary, I.O.U.S.A., pointed out not only the severity of this crisis, but also the foreign policy implications. Some very smart and very famous personalities from both parties continue to instruct ordinary citizens about the debt burden and the need to control entitlement spending. We also need their public instruction on reducing systemic risk.
Economist and columnist Paul Samuelson put some numbers on the growth in the ordinary citizens’ dependence upon the Federal pocketbook in his Washington Post column of April 29, 2012. Mr. Samuelson views the hundreds of millions of ordinary citizens as the real power in Washington. They do have votes. Voters need to have a candidate who can actually deliver change and pragmatic solutions to make one’s vote count. Otherwise, the status quo continues.
Will Presidential Election Campaign Contributions Drive the Fed Chairman Nomination?
One has only to look at the two most recent Presidential elections to see how little meaningful change has taken place in our financial market structure. The biggest banks remain huge and heavily involved in trading derivatives. They are once again very profitable and pay rich compensation. And they use their profits to influence politics.
President Obama’s top twenty donor institutions during his first run included Goldman Sachs at #2 (giving $1,013,091), JPMorgan Chase in sixth place ($808,799) and Citigroup at #7 ($736,771). The donors are the PACs and individuals associated with the institution. The data is from the Center for Responsive Politics/OpenSecrets’ website, based upon Federal Election Commission data.
In his re-election campaign, President Obama didn’t have a single big bank among his top twenty donor institutions. They’d shifted their money to Mitt Romney. Mr. Romney’s top twenty donor institutions included not only the U.S.-headquartered biggest banks, but also a number of the largest banks based outside the U.S. The list was lead by Goldman Sachs, whose PACs and employees had given $1,033,204. To see the full list, click on the following PDF file link.
Mitt Romney's Top Twenty Donor Institutions 2012 (42.2 KiB, 340 hits)
This is a big swing in campaign donations. It’s safe to say they didn’t like Dodd-Frank. Since the biggest banks remain pretty much as big as they were before Dodd-Frank, they still have concentrated wealth to influence politics, earned now with formal taxpayer backing. They are truly systemic. If Larry Summers is viewed as a champion of the biggest banks and the elite, will President Obama basically hand over the Fed Chairmanship to Mr. Summers with the 2016 Presidential election outcome for his party in mind? It certainly wouldn’t be part of change one could believe in.
Larry Summers’ Shrewd Choices of Words
Mr. Summers is clearly one of the brightest people on the planet. He carefully chooses his words to state technical truth while dodging the real issues.
In an April 2009 Businessweek interview, Maria Bartiromo asked if he had conflicts of interest that would prevent him from serving as a fair broker of bailouts, having received $5.2 million from huge hedge fund D.E. Shaw and earning $2.7 million in speaking fees from Citigroup and Goldman Sachs. He responded, “I don’t think so. But much more relevant than what I think is [the opinion of] the Office of Government Ethics.” He is referring to the government department responsible for overseeing executive branch conflicts of interest. It is headed by an official appointed by the President — to oversee the President’s own staff’s conflicts of interests. Not too tough a standard.
On March 19, 2009, on the Wall Street Journal‘s Opinion page, Mr. Summers was said to have commented that the AIG bonuses were regrettable, but couldn’t be avoided. He said, “We are a country of law. There are contracts. The government cannot just abrogate contracts.” Politicians from both sides of the aisle claimed they were appalled about hundred-million-dollar bonuses paid out of multi-billion-dollar government bailout funds. Democracy is supposed to be based upon the rule of law. However, he neglected to point out that the bailouts prevented bankruptcies that would have caused those contracts to face the rule of bankruptcy law. Instead, the contracts were fully honored solely through nonpublic decisions of a select few officials.
Larry Summers Helps Build the Bubble
Mr. Summers claims not to have been consciously part of building the financial bubble. He dances around the issue. In truth, he played a key role.
Part1: From the Reagan Era to the Clinton Era
In an article on his friend and former Treasury Secretary Robert Rubin in the Bloomberg Businessweek issue of September 30, 2012, Mr. Summers concurred with Mr. Rubin that the elimination of Glass-Steagall barriers between investment and commercial banking didn’t grant the largest commercial banks any new powers. The Glass-Steagall law passed by Congress in 1933 raised barriers between the risks assumed on investment banking trading floors and the Federally-guaranteed deposit taking and associated lending activities of traditional commercial banks. The key word in his phrase is “new.” In the article, Mr. Summers let slip that the Fed had done something prior to the 1999 passage of Gramm-Leach-Bliley (which officially removed the barriers and granted commercial banks insurance powers), but he didn’t explain.
To debunk the myth that eliminating Glass-Steagall barriers didn’t cause the bubble, the nation needs to understand some facts known by only a few. The Reagan administration’s Federal Reserve actually invited the largest commercial banks into the investment banking arena. President Reagan appointed Alan Greenspan as Chairman of the Federal Reserve in 1987. Starting in that year, from 1987 to 1995 the Fed gradually increased the traditional commercial banks’ investment banking powers in two ways.
The Fed allowed the commercial banks to underwrite commercial paper and municipal bonds through “Section 20 subsidiaries.” Then they allowed them to underwrite equities and corporate bonds. At first the Fed limited revenues from these new investment banking trading powers to five percent of the firm’s total revenues. Then the Fed increased the limit to 10%, then in 1995 to 25%. This created a huge incentive for large commercial banks to merge. If two large commercial banks merged, they would then be allowed to double their investment banking activities. Soon they were challenging the largest investment banks like Goldman Sachs. I worked at Citibank in their Section 20 subsidiary when they were at their 10% limit. Barry Ritholz also described the slow erosion of Glass-Steagall barriers on his blog, The Big Picture.
Part 2: Mr. Summers and the Clinton Era of Deregulation
As the erosion of the wall between investment banking’s trading risks and the Federal guarantee behind commercial banking’s deposit taking and lending continued in the Clinton era, the Treasury staff were quite happy to support what Reagan’s Fed had begun under Mr. Greenspan. Citicorp, parent of Citibank, merged with Traveler’s, the insurance company, in 1998 to form Citigroup. J.P. Morgan merged with Chase Manhattan in 2000 to form JPMorgan Chase. Mr. Rubin, Mr. Summers, Alan Greenspan and Republicans in Congress pushed passage of the Gramm-Leach-Bliley Act in 1999, making the Citigroup merger fully legal and making official the removal of barriers between trading desks’ securities sales and commercial banks’ lending activities. Banks or other firms could originate residential mortgage loans, package them, then sell them from their trading desks.
Securities trading wasn’t the only activity helped by Mr. Summers and friends. He played an even more direct role in limiting oversight and regulation during the growth of derivatives trading, too.
In 1998, Brooksley Born, a high-powered lawyer specializing in derivatives, had been appointed Chairman of the Commodity Futures Trading Commission by President Clinton. The CFTC regulates the futures exchanges sector of the derivatives markets in the U.S.
Chairman Born had seen the problems encountered during the expansion of over-the-counter derivatives, those traded off exchanges and by far the largest part of the derivatives markets to this day. In the mid-1990s the Government Accountability Office had also studied derivatives and reported that insurance companies’ derivatives activities were growing even faster than the banks’ derivatives trading. Chairman Born pushed an initiative, called a Concept Release, to examine the OTC derivatives market and how the CFTC’s markets and responsibilities were affected by it.
Chairman Born’s experiences at the CFTC and Mr. Summers’ actions to oppose her are well documented by the media. Mr. Summers even testified to Congress against the Concept Release as U.S. Deputy Treasury Secretary.
Note Mr. Summers’ reasoning in his testimony. He believed that regulation should be put off to allow for further study. No further studies were performed. In fact, within a few months a major hedge fund run by some of the most brilliant minds on Wall Street and a heavy user of OTC derivatives, Long-Term Capital Management, failed and was rescued from total collapse through a bailout by the largest banks, organized by the Fed. This was a systemic event, not nearly of the proportions of the 2008 financial crisis.
In his testimony Mr. Summers noted the work of the President’s Working Group, which is comprised of the chairmen of the regulatory agencies and the Treasury Secretary. Both the President’s Working Group and the GAO studied the collapse of LTCM and delivered reports that stated how OTC derivatives were poorly understood and posed major risks. Despite the collapse of Long-Term Capital Management, Congressional hand-wringing and these reports, the top Treasury officials still pushed through passage of the Commodity Futures Modernization Act of 2000, which both protected OTC derivatives from oversight and regulation and limited the CFTC’s jurisdiction.
Mr. Summers conclusion about OTC derivatives in his July 1998 testimony was that “the OTC derivatives market has grown from nothing to become a highly lucrative industry of major international importance.” Ordinary citizens can see the lucrative part still playing out in Presidential elections.
Part 3: The Bush 43 Expansion of Government Protection for Derivatives
During the Bush 43 administration, the U.S. bankruptcy code was refined in 2005 to grant even more favorable protections for derivatives in bankruptcy. Ordinary citizens don’t begin to understand these issues. But leaders who claim to care about small and medium size businesses, the greatest job creation engines in our economy, should understand the implications.
In their 2013 Margin Survey, the International Swaps and Derivatives Association estimated that $3.7 trillion in collateral backed the promises involved in global derivatives trading. 80% of the collateral was in the form of cash, deposited in accounts for safe-keeping. A conservative estimate of the amount of collateral that resides in collateral deposit accounts in U.S.-headquartered banks would show a number that is as much if not more than the entire amount of U.S.bank loans to small businesses, according to the Small Business Administration’s bank loan data. Collateral deposits cannot be lent out like normal bank deposits. They change from day to day.
In a bankruptcy a derivative contract counterparty can take the collateral and walk away. A lender, like a bank lender, not only has to wait for the bankruptcy negotiations to take their legal course, but may even have to return borrower loan payments made shortly before the bankruptcy filing.
Derivatives shifted a lot of bank capital from lending to trading after the removal of Glass-Steagall barriers. A letter from the President of the American Bankers Association to top regulators and the Treasury Secretary in September 2008 stated that a dollar of bank capital supports $7.6 dollars of bank loans. Shifting so much normal bank capital to derivatives reduces capital available for traditional bank lending. To see that letter, click on the following PDF link.
ABA-Letter-to-Fed-Officials-Sept-22-2008.pdf (469.8 KiB, 374 hits)
The Financial Superhighway of Risk and Its Toll Collectors
Larry Summers helped create the financial superhighway of risk, where all sorts of risks were broken up, repackaged, then sold from the biggest banks’ trading desks. These biggest banks collected the tolls in the form of profits. Profits on derivatives trading and securitizations. Until the bubble burst.
From the end of 1999 to the end of 2012 global OTC derivatives grew from $88 trillion to $632 trillion. These notional amounts were even larger at the end of 2012 than at the end of 2008 when the bubble was bursting. Credit derivatives grew from virtually nothing a decade ago to $58 trillion at the end of 2007 and still totaled $25 trillion at the end of 2012. These are the riskiest of derivatives. Many a non-financial person has learned that the biggest banks sell this credit protection to institutions and hedge funds that don’t even own the bonds. This is like buying fire insurance on your neighbor’s house. The IMF states that the top credits insured by the world’s largest banks through credit default swaps include the troubled sovereign debt of European countries. Former FDIC Chairman Sheila Bair has often stated how risky the credit default swaps are, sold to any institution whether they hold the bonds or not, yet no Treasury official or Congressman has pushed for a change. These are the same officials and Congressmen who say regulators should do a better job in the future.
The bubble, which Mr. Summers helped construct, was the greatest wealth transfer in the history of man, as was illustrated by a graph on The Big Picture blog showing housing prices from 1890 to 2011. Housing prices dip during the Great Depression. But even that decline doesn’t rival the pumping up of housing values starting at the end of the 1990s when Mr. Summers was in the government. Prices rose precipitously and fell equally precipitously. We are still recovering and will continue to for a long time. This was caused by the biggest banks and all who supported them pushing more and more packets of risk across their trading desks. First normal mortgage securitizations. Then mortgage securitizations with lower equity, Alt A, jumbo mortgages, subprime mortgages and liar loans. The volume of securitizations grew to massive amounts, totaling $7.4 trillion at the end of 2007. Residential mortgage securitizations may have been stopped, but derivatives still go strong.
The President Has A Choice
Mr. Summers is known to be incredibly brilliant. President Obama has other top candidates who are also very smart and experienced. They bring other attributes to the Fed Chairman role that Mr. Summers lacks, but the next Fed Chairman will sorely need. Attributes like having a bit of humility, being able to reach out to others and to remain unflappable with an even temper. His belief that he has all the answers doesn’t mesh with recent history.
The U.S. Fed and our biggest banks do not exist in a vacuum. Crises will continue to occur internationally, and we are heading to one if spending isn’t slowed here in the U.S. Mr. Summers himself described the factors in a very cynical Op-Ed in the Financial Times in August of last year. He didn’t offer any suggestion even that spending should be curtailed, much less how one might do it or what challenges the Fed might face if spending continues to grow. He just itemized the ways our entitlement and other spending will grow with supporting detail, as if we couldn’t solve this huge issue. Has he no hope? Here is the PDF link to his Financial Times Op-Ed piece.
FT-Lawrence-Summers-America's-State-Will-Expand-08192012 (181.0 KiB, 348 hits)
President Obama has choices. And he will preside over austerity in entitlement programs. That’s where we have no choice. Austerity has already begun and must continue. Whom he chooses as the next Fed Chairman will set the tone for those difficult bargaining sessions with Congress. How can Congress ask ordinary Americans to sacrifice some of their more modest benefits when the government continues to allow the most elite to earn millions, also backed by the taxpayer? Let’s hope he doesn’t choose Mr. Summers, for his sake as well as ours.