Posts Tagged ‘bailout’

Much has already been written about how a substantial number of banks have manipulated and misrepresented their LIBOR submissions for their economic benefit. But thus far, the flickr by 401(k)2012 conversation surrounding the LIBOR scandal has been primarily focused on how long the scandal has been occurring, and who knew what, when. Levy Economics Institute senior scholar Jan Kregel takes a different look in a policy note, “The Libor Scandal: The Fix is in—the Bank of England Did It!” He examines why the scandal happened in the first place, and what should be learned from it.

As background, LIBOR (London Interbank Offered Rate) is an index that represents a rough estimate of the rate at which banks are able to borrow or willing to lend on a short term basis. A select group of large banks in London submit their respective rates to Thomson Reuters, which then calculates and distributes the average rate on behalf of the industry trade group, British Bankers’ Association (BBA). That rate, despite being unverified and not subject to regulatory scrutiny, is used as a benchmark for a wide array of private lending arrangements. What this means is that many consumer loans, including adjustable-rate mortgages, private student loans, and credit cards, as well as more complex financial instruments, such as derivatives contracts, are pegged to LIBOR.

Returning to Kregel’s analysis, he finds that there were really two LIBOR scandals, perpetrated at different times, in different ways, to achieve different results.

The first scandal, according to Kregel, occurred before the 2008 global financial crisis, when traders manipulated rates up or down, depending on their positions to make as much money as possible. Kregel characterizes this rate setting as motivated purely by traders’ “venal greed.”

The second scandal, according to Kregel, occurred during the global financial crisis. As banks were on the verge of calamity, there were disparities between banks’ rate submissions. Specifically, British financial regulators were concerned that Barclays’ rate submissions were higher than others’ rate submissions, and that this likely meant other banks were only willing to lend to Barclays at higher rates. This would suggest that Barclays was in trouble and might need government aid. According to the Commodity Futures Trading Commission (CFTC), to counteract regulators’ concerns as well as any market perception that the bank’s condition was deteriorating, Barclays’ senior management directed the bank’s rate submitters to lower their rate submissions to be closer to the rates submitted by other banks. Thus, Kregel argues that the second instance of rate manipulation and misrepresentation was not due to “venal greed,” but instead self-preservation efforts.

Based on Kregel’s analysis of each LIBOR scandal, we can learn two lessons. The first is that big banks will do whatever they can to make as much money as they can, even if those activities skirt the law. The second is that big banks were propped up by regulators (foreign and domestic) in more ways than was originally apparent. Based on the facts, it is very possible that British regulators were aware of—and possibly condoned or even encouraged—Barclays’ LIBOR rigging because it would provide confidence to the market during a time of immense turmoil.

While Barclays has paid for its misdeeds to the tune of $450 million in fines and some heads have rolled, the problems that caused the misrepresentations remains the same. LIBOR continues to be a poor gauge of borrowing and lending costs, and of underlying market fundamentals. Additionally, banks that pose systemic risks such as Barclays continue to exist in a form that would again make it likely that regulators will turn a blind eye to suspicious activities, if they believe it’s necessary for economic stability.

What do Hong Kong, Singapore, Australia, and Switzerland have in common? They are four of the top five ranked countries in the conservative Heritage Foundation’s 2012 Index of Economic Freedom.

The Heritage Foundation scores countries based on a variety of factors, including the extent to which they depend on the rule of law, have limited government and regulatory efficiency, and the openness of their markets. The Freedom Index then ranks each country based on its score, categorizing them as “Free,” “Mostly Free,” “Moderately Free,” “Mostly Unfree” or “Repressed.”

For those wondering, the United States ranks tenth and is “Mostly Free.”

While Public Citizen does not endorse the index or its criteria, we do find one unique commonality between Hong Kong, Singapore, Australia, and Switzerland that is particularly noteworthy: Each of these countries imposes taxes on financial transactions to curb speculation.

Take Hong Kong for example. The top-ranked country on the index imposes a “stamp tax” of 0.3 percent on stock trades. And the Heritage Foundation extols Hong Kong’s “robust and transparent investment framework,” saying that it “has demonstrated a high degree of resilience during the ongoing global turmoil and remains one of the world’s most competitive financial and business centers.”

Thus, despite frequent scaremongering on both sides of the political spectrum that financial speculation taxes would destroy markets and devastate the economy, the top-ranked countries in the conservative think tank’s estimation prove that such taxes, when implemented properly, have done no such thing.

In fact, financial speculation taxes would likely restore the economy. That’s because they have the dual ability to curb some of the worst excesses of financial market speculation and simultaneously raise significant amounts of money to heal the ailing budget.

Short-term speculation doesn’t add value to the real economy, and it threatens near- and long-term economic havoc. This is not just speculation. (Pardon the pun.) We have witnessed the continued fallout from Wall Street’s excessively risky short-term trading activities, from the 2008 financial crisis to the 2010 flash crash and, most recently, Knight Capital’s rogue algorithm trading debacle.

A financial speculation tax in the U.S. would redirect activities to more productive and efficient allocation of capital and foster long-term investment that would boost job creation and strengthen our economy.

Even a miniscule tax, such as the 0.03 percent fee—that’s three pennies on $100 of Wall Street trading and is one-tenth the size of Hong Kong’s “stamp tax” rate—as proposed by U.S. Sen. Tom Harkin (D-Iowa) and U.S. Rep. Peter DeFazio (D-Ore.), would cut down on speculative activities like computer-driven high-frequency algorithm trading. At the same time, those pennies would quickly add up, raising more than $350 billion dollars over the next decade, according to the nonpartisan Joint Committee on Taxation.

Other countries are using financial speculation taxes successfully; it’s time we do too. The United States is in desperate need of a permanently robust and resilient economy. A financial speculation tax can help get us there.

Wednesday’s Senate Banking hearing, in which JPMorgan Chase CEO Jamie Dimon sought to explain his company’s recent trading losses, should have served as a teachable moment. First, for Jamie Dimon and other banking execs, who have fought financial reform efforts every step of the way. Their banks would be better served if they spent their time, effort, and energy improving their risk management practices. Second, for policymakers and regulators. They must resist pressures from the banking lobby to water down crucial rules meant to safeguard financial stability.

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One lesson learned from the JPMorgan’s trading loss is that we need a strong implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and specifically a strong implementation of the Volcker Rule. The Volcker Rule is a provision in Dodd-Frank that would prohibit bank holding companies, which have access to the federal safety net, from gambling and exposing American taxpayers to loss.

The effectiveness of the Volcker Rule depends largely on what regulators view as legitimate “hedging activity.” Hedging is supposed to decrease risk, in effect offsetting trading positions with one another.  However, under the currently proposed regulations to implement the Volcker Rule provision, banks are allowed to hedge within an entire trading portfolio. This means they can disregard specific risks if the portfolio viewed as a whole seems safe. In reality, portfolio hedging allows banks to trade exotic assets that can’t be directly offset.  When those exotic trades deteriorate, the bank—and possibly the American taxpayer—loses big.

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An unaddressed cause of the 2008 financial crisis was banks’ reliance on elaborate schemes called repurchase agreements, or “repos,” to fund their operations. Four years later, usual suspects like Goldman Sachs, JPMorgan Chase and Bank of America remain heavily dependent on them, endangering the financial system, as shown in a new Public Citizen report, “The Repo Ruse.”

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Repos, often associated with the largely unregulated “shadow banking” system, are loans dressed up to look like sales. In a repo agreement, the borrower, for example Goldman Sachs, “sells” an asset (such as a bond) to another party, for example a money market mutual fund. The borrower also agrees to buy back the asset, often the next day, paying a little bit more as “interest.” These sales and buybacks continue on and on until one party decides to end the agreement.

So why do the parties choose to engage in such contractual gymnastics instead of just agreeing to a conventional loan? There are two big reasons, both of which create excessive risk.

First, Congress has carved out a special exemption for repo transactions from the usual requirements of federal bankruptcy law. Traditionally, if a borrower goes bankrupt, the lender has to compete with other creditors in the bankruptcy process to recoup its investment. Not so with repo agreements. Congress has accepted the buy-and-sell charade of repos and affirmed that repo lenders can sell collateral immediately if repo borrowers go bankrupt. This permission makes repo lenders more willing than normal creditors to engage in sloppy lending practices, and more likely to dash for the exits at the first sign that their borrowers are in trouble–imperiling individual institutions and potentially triggering market panics.

Second, the fiction that repo borrowers “sell” the assets that serve as collateral permits them to cover up problems on their balance sheets.

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Grab your box of tissues, chick flick, pint of Ben & Jerry’s and – your ATM card? That’s right, Bank of America. We’ve got some breaking up to do.

You see, it’s not you; it’s me. Well, actually, it really is you. You’re too big to fail and I just don’t think you’re strong enough to make it through hard times.

But, dear banking behemoth, it doesn’t have to hurt. As smaller, less complex institutions, you wouldn’t put us all in jeopardy if your strength did slip (and a New York University study predicted you’re the most likely to).

There are things you can do to feel better.

Put a little pep back in your step with some heartfelt belted oldies. You remember that old diddy, “Breaking Up Is Hard to Do,” don’t you? Well, here’s a new spin.

There’s nothing better to cheer you up than seeing Geithner get down, Bernanke boogie and Paulson get frisky for finance. We couldn’t forget Ken Lewis or Brian Moynihan either. Let’s break it down and break them up.

Public Citizen presents, “Breaking Up Is Hard to Do,” Bank of America style.

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