Sunday, February 28, 2010

Why Financial Reform Is Stalled - Partisan gridlock is not the reason. The administration's plans are flawed, and they're encountering resistance from both sides of the aisle in Congress

Why Financial Reform Is Stalled. BY PETER J. WALLISON
Partisan gridlock is not the reason. The administration's plans are flawed, and they're encountering resistance from both sides of the aisle in Congress.WSJ, Mar 01, 2010

According to the media's narrative about Washington, the Obama administration's financial regulation proposals have not gotten through Congress because the town is gridlocked by partisan warfare. It's a simplistic story that does not require much thought to generate or accept.

Here's a better explanation: The proposals are not grounded in a valid explanation of what caused the financial crisis, reflect the same impulse to control a sector of the economy that underlies its health-care and cap-and-trade proposals, and more than anything else reflect Rahm Emanuel's iconic motto for all statists that a good crisis should never go to waste.

The administration appears to have begun its regulatory reform effort with the idea propagated by candidate Barack Obama that the financial crisis was caused by deregulation. There was never any evidence for this. The banks, which were in the most trouble, are the most heavily regulated sector of the economy and their regulation has only gotten tighter since the 1930s.

Since its proposals first met with congressional opposition, the administration has been impervious to contrary evidence, and to this day it continues to lunge for ideas that will further government control of the financial system without giving them serious thought. So we have the spectacle of Paul Volcker, having recently persuaded Mr. Obama to back the idea of restricting proprietary trading by banks or bank holding companies, telling a puzzled Senate Banking Committee he can't really define proprietary trading but knows it when he sees it. Didn't anyone in the White House ask him what it was before the president moved to restrict it?

So it goes with the rest of the administration's plan. More power to Washington, but neither a persuasive analysis of why that additional control was necessary nor a recognition of the fairly obvious consequences.

For example, the central element of the administration's reforms was to give more power to the Federal Reserve. That agency was to become the regulator of all large nonbank financial companies deemed likely to cause a systemic breakdown if they fail. These companies—securities firms, hedge funds, finance companies, insurers, bank holding companies and even the financing arms of operating companies—were to be regulated like banks.

It didn't take long for both Democrats and Republicans in Congress to see the flaws in this scheme. The Fed had been regulating the largest banks and bank holding companies for over 50 years—among the very companies that would be considered systemically important—yet it failed to see the risks they were taking or the impending danger.

How, then, did it make sense to give the Fed the vast additional power to regulate all the largest nonbank financial companies? Wouldn't designating particular companies as "systemically important," and subjecting them to special Fed regulation, signal to the markets that these companies were too big to fail? How was that a solution to the too-big-to-fail problem? And wouldn't these big companies—designated as too big to fail—then have the same preferred access to credit that enabled government-sponsored enterprises Fannie Mae and Freddie Mac to drive all competition from their market?

Then there is the proposal to give a government agency the authority to take over and "resolve" failing financial firms. Here, the administration has pointed to the chaos that followed the bankruptcy of Lehman Brothers in September 2008. To prevent that kind of breakdown, the administration says all large and "interconnected" financial firms in crisis should be dealt with by a government agency, rather than by a judge in bankruptcy proceedings.

The term "interconnected" is important here. It implies that when one large firm fails it will carry others down with it, causing a systemic crisis. But that is clearly not the lesson of Lehman. Although the company went suddenly and shockingly into bankruptcy, none of its large financial counterparties failed. The systemic significance of "interconnectedness" proved to be a myth.

To be sure, there was a freeze-up in lending after Lehman. But that episode demonstrated the power of moral hazard—the tendency of government action to distort private decision-making. After Bear Stearns was rescued by the Fed in March 2008, market participants assumed that all companies larger than Bear would be rescued in the future. As a result, they did not take the steps to protect themselves against counterparty failure that would have been prudent in a panicky market. When Lehman was not rescued, all market participants immediately had to review the credit standing of their counterparties. No wonder lending temporarily froze.

The same failure to understand the power of moral hazard is what makes the administration's call for a resolution authority most inapt and troubling. Although the administration has argued, and some in Congress believe, that moral hazard and too-big-to-fail would be curbed by a resolution authority, the opposite is true. Both would be enhanced.

This is because the principal danger of moral hazard—the key to its adverse effects on private decision-making—is its impact on creditors and counterparties. The fact that shareholders and managements will lose everything in a government resolution is largely irrelevant. What really matters are the lessons creditors draw about how they will be treated. And it is clear creditors will be treated far more favorably in a government resolution process than in a bankruptcy.

To understand why this is true, consider the administration's reasons for preferring a government resolution process. The claim is that large, interconnected firms will drag down others when they fail. The remedy for this is to make sure their creditors and counterparties are fully paid when the takeover occurs. That's why the Fed made Goldman Sachs and others whole when it rescued the insurance giant AIG. It's also what distinguishes a government resolution process from a bankruptcy, where a stay is imposed on most payments to creditors when the bankruptcy petition is filed.

Creditors will realize that by lending to large companies that might be taken over and resolved by the government, their chances of being fully paid are better than if they lend to others that might not. Thus a resolution authority will enhance moral hazard not reduce it—and as creditors increasingly assume that large firms will be rescued, the too-big-to-fail phenomenon will grow, not decline. In the end, a resolution authority becomes, in effect, a permanent Troubled Asset Relief Program.

The image of partisan gridlock standing in the way of sensible financial regulation is wildly misleading. Twenty-seven Democrats in the House voted against the Barney Frank bill that mostly mirrored the administration plan. Democrats and Republicans in the Senate Banking Committee revolted against the first bill offered by Chairman Chris Dodd. That bill adopted most of the administration's flawed ideas.

Now Mr. Dodd is trying to negotiate a Plan B. But the longer he channels the White House, the longer it will take to get a bill that both Democrats and Republicans can support.

Mr. Wallison is a senior fellow at the American Enterprise Institute.

Thursday, February 25, 2010

Europeans' worship of the state and corresponding suspicion of free markets doom their countries to economic stagnation

Europe's Crisis of Ideas. By BRET STEPHENS
Europeans' worship of the state and corresponding suspicion of free markets doom their countries to economic stagnation.WSJ, Feb 23, 2010

Europe is in a crisis. Superficially, the crisis is about money: the Greek budget, a German-led bailout, the risk of contagion, moral hazard, the fragility of the euro. Fundamentally, it's a crisis of ideas.

At last month's meeting of the World Economic Forum in Davos, Greek Prime Minister George Papandreou offered a view on the source of Europe's woes. "This is an attack on the euro zone by certain other interests, political or financial," he said, without specifying who or what those interests might be. In Madrid, the government has reportedly ordered its intelligence service to investigate "collusion" between U.S. investors and the media to bring Spain's economy low.

Maybe the paladins of Spanish and Greek politics seriously imagine that hedge-fund managers sit around dimly lit conference rooms like so many Lex Luthors and—cue the sinister cackles—decide on a whim to sink this or that economy. Or maybe they think there are political dividends to reap by playing to peanut galleries already inclined toward these kinds of fantasies.

Whichever way, the recrudescence of conspiracy-theory politics, among governments that supposedly belong to the First World, is just one symptom of Europe's intellectual malaise. On the other end of the spectrum is the view that the Greek crisis is the perfect opportunity to expand the regulatory reach and taxing authority of Brussels. Never mind that Greece's economic woes are transparently the result of a government spending beyond its means while failing to promote growth. In this reading of events, the ideal resolution is to extend the prerogatives of a bureaucracy to an even higher level of unaccountability. This is a bit like saying that if your toenail appears to be seriously infected, consider having brain surgery.

Why do Europeans so often find themselves trapped in this sterile dialectic of populist obscurantism and technocratic irrelevancy? Largely because those are the options that remain when other modes of analysis and prescription have been ruled out of bounds. "All European economic policies are the cultural derivatives of one dominant, nearly totalitarian statist ideology: the state is good, the market is bad," says French economist Guy Sorman. The free market, he adds, is "perceived as fundamentally American, while statism is the ultimate form of patriotism."

In the U.S., faith in the general efficacy of markets isn't simply a cultural inheritance. It is sustained by the work of serious university economics departments; think tanks like the Hoover Institution and grant-makers like the Kauffman Foundation, plus a few editorial pages here and there. It's also the default position of the Republican Party, at least rhetorically.

By contrast, in continental Europe the dominant mode of conservative politics is sometimes pro-business but rarely pro-market: During his 12-year presidency of France, Jacques Chirac railed against "Anglo-Saxon ultraliberalism," a phrase that became so ubiquitous as to almost obscure its crassly xenophobic appeal. There are think tanks, but they are almost invariably funded by political parties and hew to the party line. Not a single economics faculty in Europe is remotely competitive with a Chicago or a George Mason: Since 1990, only three of the 36 winners of the Nobel Prize in Economics were then affiliated with a European university.

Then there is the media. Last week, German Foreign Minister Guido Westerwelle, who leads the country's market-friendly Free Democrats, took to the pages of Die Welt to lament that Germany's working poor make less than welfare recipients. "For too long," he wrote, "we have perfected in Germany the redistribution [of wealth], forgetting where prosperity comes from."

For his banal observations, Mr. Westerwelle was roundly accused of "[defaming] millions of welfare recipients" and urged to apologize to them. It takes a remarkably stultified intellectual climate for an op-ed to spark this kind of brouhaha: It is the empire of the Emperor's New Clothes, adapted to the 21st century welfare state.

This is all the more remarkable given that Europe's economic travails aren't exactly difficult to grasp. Greece in a nutshell? It costs $10,218 to obtain all the permitting needed to start a new business there, according to Harvard economist Alberto Alesina. In the U.S., it takes $166. But tyrannies of thought are hard to break, especially when the beneficiaries of state largess—from college students to government workers to captains of subsidized industries—become a political majority. The U.S. may now be approaching just such a point itself.

Is there a way out? "I am deeply convinced," says Mr. Sorman, "that I belong to a continuous tradition of liberty against the state, with a fine pedigree: Montesquieu, Tocqueville, Jean Baptiste Say, Jacques Rueff, Raymond Aron, Jean-Francois Revel." Not an Anglo-Saxon name among them. Europe's recovery—and the recovery of Europe—will come only when they are no longer prophets without honor in their own lands.

Tuesday, February 23, 2010

It would be better for our economy to enforce anti-manipulation laws, and require that speculators have enough capital to cover their risks, than to attempt to squash speculation

In Defense of Financial Speculation. By DARRELL DUFFIE
It is not the same thing as market manipulation.WSJ, Feb 24, 2010

George Soros, Washington Democratic Sen. Maria Cantwell and others are proposing to curb speculative trading and even outlaw it in credit default swap (CDS) markets. Their proposals appear to be based on a misconception of speculation and could harm financial markets.

Speculators earn a profit by absorbing risk that others don't want. Without speculators, investors would find it difficult to quickly hedge or sell their positions.

Speculators also provide us with information about the fundamental values of investments. When the fundamentals appear favorable, they buy. Otherwise, they sell. If their forecasts are correct, they profit. This causes prices to more accurately forecast an investment's value, spreading useful information. For example, the clearest evidence that Greece has a serious debt problem was the run-up of the price for buying CDS protection against the country's default.

Is this sort of speculation wrong? I have not heard why.

Those who call for stamping out speculation may be confused between speculation and market manipulation. Manipulation occurs when investors "attack'' a financial market in order to profit by changing the value of an investment. Profitable speculation occurs when investors accurately forecast an investment's fundamental strength or weakness.

An example of manipulation is an attack on a currency with a fixed exchange rate in an attempt to cause a devaluation of that currency. Mr. Soros allegedly attacked the British pound in 1992 and the Malaysian ringgit in 1997. An attack on the equity or CDS of a bank could create fears of insolvency, leading to a bank run and allowing the manipulator to profit from his attack.

In the week of Lehman Brothers' bankruptcy in September 2008, John Mack, then CEO of Morgan Stanley, suggested that the difficulties facing his firm stemmed from such an attack. But firms complaining of unfounded short-selling often had real problems beforehand.

A market manipulator can also attempt to profit by "cornering" a market. This is done by holding such a large fraction of the supply of an asset that anyone who wants to buy that asset is at the mercy of the corner holder when negotiating a price.

The market for silver was temporarily cornered in 1979-80, when Nelson Bunker Hunt and his brother William Herbert Hunt held silver derivatives representing approximately half of annual global silver production. In the end, the Hunt brothers were unable to maintain a corner. As they sold, silver prices fell, causing them calamitous losses.

Market manipulation for profit is not easily done. If the fundamentals of supply and demand suggest that the value of something is $100, then a manipulator must buy at prices above $100 in order to drive the price up or to accumulate a monopolistic position. He then owns an asset that on paper could be worth more than what he paid for it. However, he must sell his asset in order to cash in on his profit. This spurs the price of that asset to fall, as the Hunt brothers learned.

Simply driving up the price, as speculators are alleged to have done in the oil market in 2008, is not enough. To make a profit, a manipulator needs to obtain monopolistic control of the supply. Given the size of the oil market, that seems implausible, absent a major and sustained conspiracy.

In the United States, trade with an intent to manipulate financial markets is generally illegal. Regulators should keep anti-manipulation laws up to date and aggressively monitor potential violators.

Speculation is not necessarily harmless. If a large speculator does not have enough capital to cover potential losses, he could destabilize financial markets if his position collapses. The Over-the-Counter Derivatives Markets Act, which could come up for a vote in the Senate soon, will hopefully reduce such risks.

It would be better for our economy to enforce anti-manipulation laws, and require that speculators have enough capital to cover their risks, than to attempt to squash speculation.

Mr. Duffie is a professor of finance at Stanford University's Graduate School of Business.

My Gift to the Obama Presidency - Bush lawyers were protecting the executive's power to fight a vigorous war on terror

My Gift to the Obama Presidency. By JOHN YOO
Though the White House won't want to admit it, Bush lawyers were protecting the executive's power to fight a vigorous war on terror.
WSJ, Feb 24, 2010

Barack Obama may not realize it, but I may have just helped save his presidency. How? By winning a drawn-out fight to protect his powers as commander in chief to wage war and keep Americans safe.

He sure didn't make it easy. When Mr. Obama took office a year ago, receiving help from one of the lawyers involved in the development of George W. Bush's counterterrorism policies was the furthest thing from his mind. Having won a great electoral victory, the new president promised a quick about-face. He rejected "as false the choice between our safety and our ideals" and moved to restore the law-enforcement system as the first line of defense against a hardened enemy devoted to killing Americans.

In office only one day, Mr. Obama ordered the shuttering of the detention facility at Guantanamo Bay, followed later by the announcement that he would bring terrorists to an Illinois prison. He terminated the Central Intelligence Agency's ability to use "enhanced interrogations techniques" to question al Qaeda operatives. He stayed the military trial, approved by Congress, of al Qaeda leaders. He ultimately decided to transfer Khalid Sheikh Mohammed, the planner of the 9/11 attacks, to a civilian court in New York City, and automatically treated Umar Farouk Abdulmutallab, who tried to blow up a Detroit-bound airliner on Christmas Day, as a criminal suspect (not an illegal enemy combatant). Nothing better could have symbolized the new president's determination to take us back to a Sept. 10, 2001, approach to terrorism.

Part of Mr. Obama's plan included hounding those who developed, approved or carried out Bush policies, despite the enormous pressures of time and circumstance in the months immediately after the September 11 attacks. Although career prosecutors had previously reviewed the evidence and determined that no charges are warranted, last year Attorney General Eric Holder appointed a new prosecutor to re-investigate the CIA's detention and interrogation of al Qaeda leaders.

In my case, he let loose the ethics investigators of the Justice Department's Office of Professional Responsibility (OPR) to smear my reputation and that of Jay Bybee, who now sits as a federal judge on the court of appeals in San Francisco. Our crime? While serving in the Justice Department's Office of Legal Counsel in the weeks and months after 9/11, we answered in the form of memoranda extremely difficult questions from the leaders of the CIA, the National Security Council and the White House on when interrogation methods crossed the line into prohibited acts of torture.

Rank bias and sheer incompetence infused OPR's investigation. OPR attorneys, for example, omitted a number of precedents that squarely supported the approach in the memoranda and undermined OPR's preferred outcome. They declared that no Americans have a right of self-defense against a criminal prosecution, not even when they or their government agents attempt to stop terrorist attacks on the United States. OPR claimed that Congress enjoyed full authority over wartime strategy and tactics, despite decades of Justice Department opinions and practice defending the president's commander-in-chief power. They accused us of violating ethical standards without ever defining them. They concocted bizarre conspiracy theories about which they never asked us, and for which they had no evidence, even though we both patiently—and with no legal obligation to do so—sat through days of questioning.

OPR's investigation was so biased, so flawed, and so beneath the Justice Department's own standards that last week the department's ranking civil servant and senior ethicist, David Margolis, completely rejected its recommendations.

Attorney General Holder could have stopped this sorry mess earlier, just as his predecessor had tried to do. OPR slow-rolled Attorney General Michael Mukasey by refusing to deliver a draft of its report until the 2008 Christmas and New Year holidays. OPR informed Mr. Mukasey of its intention to release the report on Jan. 12, 2009, without giving me or Judge Bybee the chance to see it—as was our right and as we'd been promised.

Mr. Mukasey and Deputy Attorney General Mark Filip found so many errors in the report that they told OPR that the entire enterprise should be abandoned. OPR decided to run out the clock and push the investigation into the lap of the Obama administration. It would have been easy for Mr. Holder to concur with his predecessors—in fact, it was critical that he do so to preserve the Justice Department's impartiality. Instead the new attorney general let OPR's investigators run wild. Only Mr. Margolis's rejection of the OPR report last week forced the Obama administration to drop its ethics charges against Bush legal advisers.

Why bother fighting off an administration hell-bent on finding scapegoats for its policy disagreements with the last president? I could have easily decided to hide out, as others have. Instead, I wrote numerous articles (several published in this newspaper) and three books explaining and defending presidential control of national security policy. I gave dozens of speeches and media appearances, where I confronted critics of the administration's terrorism policies. And, most importantly, I was lucky to receive the outstanding legal counsel of Miguel Estrada, one of the nation's finest defense attorneys, to attack head-on and without reservation, each and every one of OPR's mistakes, misdeeds and acts of malfeasance.

I did not do this to win any popularity contests, least of all those held in the faculty lounge. I did it to help our president—President Obama, not Bush. Mr. Obama is fighting three wars simultaneously in Iraq, Afghanistan, and against al Qaeda. He will call upon the men and women serving under his command to make choices as hard as the ones we faced. They cannot meet those challenges with clear minds if they believe that a bevy of prosecutors, congressional committees and media critics await them when they return from the battlefield.

This is no idle worry. In 2005, a Navy Seal team dropped into Afghanistan encountered goat herders who clearly intended to inform the Taliban of their whereabouts. The team leader ordered them released, against his better military judgment, because of his worries about the media and political attacks that would follow.

In less than an hour, more than 80 Taliban fighters attacked and killed all but one member of the Seal team and 16 Americans on a helicopter rescue mission. If a president cannot, or will not, protect the men and women who fight our nation's wars, they will follow the same risk-averse attitudes that invited the 9/11 attacks in the first place.

Without a vigorous commander-in-chief power at his disposal, Mr. Obama will struggle to win any of these victories. But that is where OPR, playing a junior varsity CIA, wanted to lead us. Ending the Justice Department's ethics witch hunt not only brought an unjust persecution to an end, but it protects the president's constitutional ability to fight the enemies that threaten our nation today.

Mr. Yoo, a law professor at the University of California, Berkeley and visiting scholar at the American Enterprise Institute, was a Justice Department official from 2001-03. He is the author, among other books, of "Crisis and Command: A History of Executive Power from George Washington to George W. Bush" (Kaplan, 2010).

Financial Amplification Mechanisms and the Federal Reserve’s Supply of Liquidity during the Crisis

Financial Amplification Mechanisms and the Federal Reserve’s Supply of Liquidity during the Crisis. By Asani Sarkar and Jeffrey Shrader
Federal Reserve Bank of NY, February 2010

The small decline in the value of mortgage-related assets relative to the large total losses associated with the financial crisis suggests the presence of financial amplification mechanisms, which allow relatively small shocks to propagate through the financial system. We review the literature on financial amplification mechanisms and discuss the Federal Reserve’s interventions during different stages of the crisis in light of this literature. We interpret the Fed’s early-stage liquidity programs as working to dampen balance sheet amplifications arising from the positive feedback between financial constraints and asset prices. By comparison, the Fed’s later-stage crisis programs take into account adverse-selection amplifications that operate via increases in credit risk and the externality imposed by risky borrowers on safe ones. Finally, we provide new empirical evidence that increases in the Federal Reserve’s liquidity supply reduce interest rates during periods of high liquidity risk. Our analysis has implications for the impact on market prices of a potential withdrawal of liquidity supply by the Fed.

"The President's Proposal" on health-care

ObamaCare at Ramming Speed. WSJ Editorial
The White House shows it has no interest in compromise.WSJ, Tuesday, February 23, 2010 As of 3:09 AM

A mere three days before President Obama's supposedly bipartisan health-care summit, the White House yesterday released a new blueprint that Democrats say they will ram through Congress with or without Republican support. So after election defeats in Virginia, New Jersey and even Massachusetts, and amid overwhelming public opposition, Democrats have decided to give the voters what they don't want anyway.

Ah, the glory of "progressive" governance and democratic consent.

"The President's Proposal," as the 11-page White House document is headlined, is in one sense a notable achievement: It manages to take the worst of both the House and Senate bills and combine them into something more destructive. It includes more taxes, more subsidies and even less cost control than the Senate bill. And it purports to fix the special-interest favors in the Senate bill not by eliminating them—but by expanding them to everyone.

The bill's one new inspiration is a powerful federal board that would regulate premiums in the individual insurance market. In all 50 states, insurers are already required to justify premium increases to insurance commissioners, who generally have the power to give a regulatory go-ahead, or not. But their primary concern is actuarial soundness and capital standards, making sure that companies have enough cash to pay claims.

The White House wants to create another layer of review that will be able to reject any rate increase that is "unreasonable or unjustified." Any insurer deemed guilty of such an infraction by this new bureaucracy "must lower premiums, provide rebates, or take other actions to make premiums affordable." In other words, de facto price controls.

Insurance premiums are rising too fast; therefore, premium increases should be illegal. Q.E.D. The result of this rate-setting board will be less competition in the individual market, as insurers flee expensive states or regions, or even a cascade of bankruptcies if premiums are frozen and the cost of the care they are expected to cover continues to rise. For all the Dickensian outrage about profiteering by WellPoint and other companies, insurance is a low-margin business even for health care, and at least 85 cents of the average premium dollar, usually more, is devoted to actual health services.

Price controls are always the first resort of national health care—i.e., Medicare's administered prices for doctors and hospitals. This new White House gambit is merely a preview of ObamaCare's inevitable planned medical economy, which will reduce choice and quality.

The coercive flavor that animates this exercise is best captured in the section that purports to accept the Senate's "grandfather clause" allowing people who like their current health plan to keep it. Except that "The President's Proposal adds certain consumer protections to these 'grandfathered' plans. Within months of legislation being enacted, it requires plans . . . prohibits . . . mandates . . . requires . . . the President's Proposal adds new protections that prohibit . . . ban . . . and prohibit . . . The President's Proposal requires . . ." After all of these dictates, no "grandfathered" plan will exist.

Meanwhile, the new White House plan further vitiates the remnants of cost-control that remained in the House and Senate bills. Now the highly vaunted excise tax on high-cost insurance plans won't kick in until 2018, whereas it would have started in 2013 in the Senate bill, and this tax will only apply to coverage that costs more than $27,500.

Very few plans ever reach that threshold, and sure enough, this is the same $60 billion deal the White House cut in December with union leaders who have negotiated very costly benefits. Now it is extended to all to avoid the taint of political favoritism.

While the White House claims to eliminate the "Cornhusker Kickback," the Medicaid bribe that bought Nebraska Senator Ben Nelson's vote, political appearances are deceiving. As with the union payoff, what the White House really does is broaden the same to all states, with all new Medicaid spending through 2017 and 90% after 2020 transferred to the federal balance sheet. Governors will love this ruse, but national taxpayers will pay more.

And more again, because the White House has adopted the House's firehose insurance subsidies. People earning up to 400% of the poverty line—or about $96,000 for a family of four in 2016—will qualify for government help, and, naturally, this new entitlement is designed to expand over time.

The Administration also claims to have discarded the House's 5.4-percentage-point surtax on joint-filers earning more than $1 million a year, but it sneaks it back in by expanding the Senate's expansion of the 2.9% Medicare payroll tax to joint income about $250,000. The White House would now apply that tax for the first time to income from "interest, dividends, annuities, royalties and rents," details to come.

The larger political message of this new proposal is that Mr. Obama and Democrats have no intention of compromising on an incremental reform, or of listening to Republican, or any other, ideas on health care. They want what they want, and they're going to play by Chicago Rules and try to dragoon it into law on a narrow partisan vote via Congressional rules that have never been used for such a major change in national policy. If you want to know why Democratic Washington is "ungovernable," this is it.

Monday, February 22, 2010

Risk and Discipline in the Financial Markets: New resolution authority can help convince banks they're not too big to fail

Risk and Discipline in the Financial Markets. By ARTHUR LEVITT
New resolution authority can help convince banks they're not too big to fail.WSJ, Feb 22, 2010

There is now a high probability that the greatest financial crisis in three generations will yield not one piece of meaningful financial regulatory reform. Perhaps the last best chance to rescue the situation rests with Sens. Christopher Dodd (D., Conn.) and Robert Corker (R., Tenn.), who are at work on a compromise bill.

Their goal should not be just any bill, but one that addresses the corrosive effects of a system in which massive institutional failure and total loss are impossible. The policy bias against letting failure occur was regrettable but excusable in the fall of 2008. Now there is no reason for it.

Too many regulators, politicians, bankers, credit rating agencies and others have believed failure was not an option. In financial markets, when people take risks and don't anticipate failure, they take greater risks and the resulting failure becomes far more damaging.

There is still time for the White House and Congress to re-institute the principle of failure in our financial marketplace. It may not be as sexy as the creation of a consumer protection agency or a reorganization of the federal regulatory landscape. But it is essential.

It can be done in two ways. First we should address the problem of "too big to fail," in which large financial institutions are not allowed to fail because of the impact their failure would have on the rest of the market. Second is the problem of "too interconnected to fail," which is a variation on the same theme: when a financial institution's positions in the unregulated and non-transparent derivatives markets are so complex, so secretive, and so leveraged that to unwind them quickly is either impossible or dangerous.

The problem of "too big to fail" is behind President Obama's support of the so-called Volcker rule, which would prevent banks from getting too big by limiting their ability to engage in proprietary trading or run their own hedge funds or private equity funds. But this would not end the de facto government backing of big banks. Indeed, it is premised on the idea that because these banks will be protected from failure, they should not be permitted to engage in these activities. Far from ending the problem of "too big to fail," the Volcker rule practically institutionalizes it.

The only reasonable solution to "too big to fail" is the creation of a resolution authority that makes the failure of any financial institution possible and orderly—something I am glad to say Paul Volcker has supported as well. The rights and responsibilities of equity holders, bond holders, other creditors and management would be spelled out—in advance. If a bank or financial institution should require the direction of a resolution authority, failure might not be the only option, but it would remain the first one. That prospect alone would reintroduce the risk of failure in our financial markets.

The problem of "too interconnected to fail" is just as critical. The unregulated and fast-growing market for derivative products helped cause the financial crisis.

There were—and are—several features to this market that make it a petri dish for systemic risk. There is no transparency around volumes, pricing and outstanding positions. These derivatives often do not go through central clearing houses, which validate and guarantee counterparty trades. Traders often rely on collateral positions and favorable but disruptive unwinding practices to protect themselves from the significant risks associated with derivative instruments.

Even now, there is no reason for traders to be more focused on credit discipline because these derivatives enjoy a special bankruptcy court protection normally extended only to certain government securities and foreign exchange transactions. Such protections were put in place so that government repos, which are vital to the funding of government operations, are not frozen by bankruptcy court actions. But the cost of these protections when extended to OTC derivatives is paid for by other creditors—as Lehman's creditors are now discovering.

All of these features make derivatives a source of "too interconnected to fail" and invite regulatory action. Several steps should follow:

First, we must officially end the unregulated status of these markets going forward—something that has been proposed before, but to no avail.

Second, rather than determining in advance which new derivatives need to be cleared, we should create incentives for that process by setting higher capital requirements on noncleared contracts. Not all derivatives will go to clearing houses—but a great majority of them will.

Third, to meet the greater volume, we need to invest in the institutional capacity of the clearing houses.

And finally, Congress should set a date certain—two years from now—at which point the special bankruptcy status of noncentrally cleared derivatives will be eliminated. This rule would only apply to new contracts.

These steps would re-introduce real credit discipline, while improving market transparency at all levels—all without forcing federal regulators to struggle to develop a rule that would somehow define a standard contract in a marketplace where variety and diversity is the norm.

Some will say that regulating OTC derivatives and creating a strong resolution authority would make the U.S. a "less competitive" financial marketplace. I doubt it. Investors will go to the financial marketplaces that offer the best protections against systemic risk. That has always been true and is especially true today.

Mr. Levitt was chairman of the Securities and Exchange Commission from 1993-2001 and is currently an adviser to Goldman Sachs.

Friday, February 19, 2010

Complex Loans Didn't Cause the Crisis - And the Consumer Financial Protection Agency wouldn't protect us from another one

Complex Loans Didn't Cause the Crisis. By TODD ZYWICKI
And Obama's Consumer Financial Protection Agency wouldn't protect us from another one.
WSJ, Feb 19, 2010

Regulatory reform that can improve competition and consumer choice in financial services is long overdue. But no new federal bureaucracy such as the Obama administration's proposed Consumer Financial Protection Agency (CFPA) is needed to bring that about.

More importantly, the administration is incorrect in claiming that such an agency would have prevented the present financial crisis and is necessary to prevent the next crisis. On the contrary, such an agency might be the first step toward more problems.

During the housing boom bankers made a raft of extraordinarily foolish loans. Some were the result of lenders defrauding borrowers; probably at least as many were the product of borrowers defrauding lenders. But there is no evidence, as Elizabeth Warren (a champion of CFPA and chair of the TARP Congressional Oversight Panel) recently asserted on these pages, that lender fraud was the overriding cause of the crisis.

The bank loans were not foolish because borrowers didn't realize what they were doing. They were foolish because of the incentives they created for borrowers, especially when housing prices turned south.

There were three distinct stages of the housing crisis. In the first, the Federal Reserve's extremely low interest rates from 2001-2004 induced consumers to switch from fixed to adjustable rate mortgages and drew short-term speculators and house-flippers into the market in certain cities. The Fed's increase in short-term interest rates over the next two years increased homeowner payments and precipitated a round of defaults.

My own research confirms the analysis provided by University of Texas economist Stan Leibowitz on these pages last July: The initial onset of the foreclosure crisis was a problem of adjustable-rate mortgages, whether prime or subprime. It was not initially a subprime problem.

In the second phase, falling home prices provided incentives for owners whose mortgages were under water to walk away from their houses. And in the third phase, which we are now experiencing, traditional macroeconomic factors like unemployment led to more foreclosures—especially where homeowners' mortgages are already underwater. Reflecting this situation, the Mortgage Bankers Association reports that the fastest-rising segment of foreclosures in recent months has been traditional prime, fixed-rate mortgages.

None of this analysis has anything to do with fraud or consumer protection problems. Consumers rationally switched to adjustable-rate mortgages when their prices fell relative to fixed-rate mortgages—a pattern that has repeated itself numerous times since the 1980s. And when housing prices fell, underwater homeowners rationally responded by walking away from their houses. The proliferation of mortgages with minimal downpayments, interest-only or even negative amoritzation terms, and cash-out refinances meant that many consumers fell into negative equity territory much more rapidly than they would have otherwise.

Regulators may want to limit mortgages that provide so many borrowers with such strong incentives to walk away when housing prices fall. They may want to prohibit lenders from making loans with minimal downpayments or interest-only loans that result in consumers having minimal equity in their homes. But that's an issue of safety and soundness, not protection against fraud. With respect to ARMs, the obvious solution is a less-erratic Federal Reserve interest rate policy. ARMs have been in widespread use for 25 years (and are common in the rest of the world) without mishap like in the current cycle.

So the problem isn't consumer gullibility or ignorance. Borrowers have shown they understand, and act on, the incentives they face all too well.

It is worth remembering that, although the banking crisis was a national crisis, the foreclosure crisis is concentrated in four states—Arizona, California, Florida and Nevada—that comprise almost half of the mortgages in foreclosure. Even within those states, foreclosures are concentrated within a handful of hot-spots such as Las Vegas, Miami, Phoenix and the Inland Empire region of California. It is unlikely that borrowers in these cities are more gullible than borrowers elsewhere. Evidence does suggest, however, that there were a larger number of speculators and home-flippers in those cities than elsewhere.

This is not to deny that we are overdue for a comprehensive reform of consumer credit regulation. Over the years, federal laws governing disclosures have become encrusted with an ever-thickening coat of litigation- and regulation-imposed barnacles.

One example, according to Federal Reserve economists Thomas Durkin and Gregory Elliehausen in a book to be published this year, involves the Truth in Lending Act, which has grown from a simple effort to standardize disclosures on consumer credit to a morass.

Regulatory mandates and lawsuit fears are largely responsible for the mind-numbing length of a typical credit-card agreement and monthly statement. The most recent mandate-induced clutter requires the monthly statement to disclose how long it would take to repay the balance by making the minimum payment while making no new charges. According to a Federal Reserve Study by Mr. Durkin, only 4% of consumers would even consider this option.

Similarly, a 2007 Federal Trade Commission staff report by economists James Lacko and Janis Pappalardo documented the convoluted nature of current mortgage disclosure rules (which fail to convey key costs) and presented prototype disclosures that significantly improved key mortgage cost disclosures. Yet such common-sense proposals remain buried in the bureaucracy.

What's needed is simplified and streamlined regulation, not another agency.

Policies based on a misdiagnosis of the true nature of the problem might actually lay the seeds for the next crisis. For example, Ms. Warren rails in her op-ed about "tricks and traps" such as "universal default" provisions in credit-card contracts, where a failure to pay one credit-card bill can trigger a default on another one. Yet it is obvious that a consumer's failure to pay some of his bills provides valuable information about the likelihood of default on his credit-card bill (universal default provisions are common in commercial loans for this reason).

Thus a lender's elimination of universal default will have to be offset by higher interest rates or fees. To the extent that a CFPA makes access to credit cards less available, excluded borrowers will inevitably shift to more expensive alternatives such as payday lending or pawn shops. If the CFPA were to impose bans on efficient risk-based pricing by lenders in the name of vague claims about "fairness," the likely result will be to increase overall risk and make the next financial crisis more likely.

The financial crisis resulted primarily from the rational behavior of borrowers and lenders responding to misaligned incentives, not fraud or borrower stupidity. Policies that fail to appreciate the difference will not protect, and may hurt, the very consumers they are intended to protect.

Mr. Zywicki is a law professor at George Mason University and a senior scholar at the Mercatus Center. This op-ed is based in part on a Mercatus working paper, "The Housing Market Crash."

Tuesday, February 9, 2010

Yoo: Obama misunderstands his constitutional role

Getting It Backwards. By John Yoo

Monday, February 8, 2010

GMO Panel deliberations on the paper by de Vendômois et al. (2009, A Comparison of the Effects of Three GM Corn Varieties on Mammalian Health, International Journal of Biological Sciences, 5: 706-726)

EFSA: Adopted part of the minutes of the 55th plenary meeting of the Scientific Panel on Genetically Modified Organisms held on 27-28 January 2010 to be published at

GMO Panel deliberations on the paper by de Vendômois et al. (2009, A Comparison of the Effects of Three GM Corn Varieties on Mammalian Health, International Journal of Biological Sciences, 5: 706-726)
The EFSA GMO Panel has considered the paper by de Vendômois et al. (2009, A Comparison of the Effects of Three GM Corn Varieties on Mammalian Health, International Journal of Biological Sciences, 5: 706-726), a statistical reanalysis of data from three 90-day rat feeding studies already assessed by the GMO Panel (EFSA, 2003a,b; EFSA 2004a,b; EFSA 2009b,c). The GMO Panel concludes that the authors’ claims, regarding new side effects indicating kidney and liver toxicity, are not supported by the data provided in their paper. There is no new information that would lead it to reconsider its previous opinions on the three maize events MON810, MON863 and NK603, which concluded that there were no indications of adverse effects for human, animal health and the environment.

The GMO Panel notes that several of its fundamental statistical criticisms (EFSA, 2007a,b) of the authors' earlier study (Seralini et al., 2007) of maize MON863 are also applicable to the new paper by de Vendômois et al. In the GMO Panel's extensive evaluation of Seralini et al. (2007), reasons for the apparent excess of significant differences found for MON863 (8%) were given and it was shown that this raised no safety concerns. The percentage of variables tested reported by de Vendômois et al. that were significant for NK603 (9%) and MON810 (6%) were of similar magnitude to that for MON863.

The GMO Panel considers that de Vendômois et al.: (1) make erroneous statements concerning the use of reference varieties to provide estimates of variability that allow equivalence testing to place statistically significant results into biological context as advocated by EFSA (2008, 2009a); (2) do not use the available information concerning normal background variability between animals fed with different diets, to place observed differences into biological context; (3) do not present results using their False Discovery Rate methodology in a meaningful way; (4) give no evidence to relate wellknown gender differences in response to diet to claims of effects due to the respective GMOs; (5) estimate statistical power based on inappropriate analyses and magnitudes of difference.

The significant differences highlighted by de Vendômois et al. have all been considered previously by the GMO Panel in its previous opinions on the three maize events MON810, MON863 and NK603.  The study by de Vendômois et al. provides no new evidence of toxic effects. The approach used by de Vendômois et al. does not allow a proper assessment of the differences claimed between the GMOs and their respective counterparts for their toxicological relevance because: (1) results are presented exclusively in the form of percentage differences for each variable, rather than in their actual measured units; (2) the calculated values of the toxicological parameters tested are not related to the normal range for the species concerned; (3) the calculated values of the toxicological parameters tested are not compared with ranges of variation found in test animals fed with diets containing different reference varieties; (4) the statistically significant differences did not show consistency patterns over endpoint variables and doses; (5) the inconsistencies between the purely statistical arguments of de Vendômois et al., and the results for these three animal feeding studies which relate to organ pathology, histopathology and histochemistry, are not addressed. Regarding claims made by de Vendômois et al.  concerning the inadequacy of the experimental design of these three animal feeding studies, the GMO Panel notes that they were all carried out to agreed internationally-defined standards consistent with OECD protocols. 


-  EFSA, 2003a. Opinion of the Scientific Panel on genetically modified organisms (GMO) on a request from the Commission related to the safety of foods and food ingredients derived from herbicidetolerant genetically modified maize NK603, for which a request for placing on the market was submitted under Article 4 of the Novel Food Regulation (EC) No 258/97 by Monsanto.
-  EFSA, 2003b. Opinion of the Scientific Panel on genetically modified organisms (GMO) on a request from the Commission related to the Notification (Reference CE/ES/00/01) for the placing on the market of herbicide-tolerant genetically modified maize NK603, for import and processing, under Part C of Directive 2001/18/EC from Monsanto.
-  EFSA, 2004a. Opinion of the Scientific Panel on genetically modified organisms (GMO) on a request from the Commission related to the Notification (Reference C/DE/02/9) for the placing on the market of insect-protected genetically modified maize MON 863 and MON 863 x MON 810, for import and processing, under Part C of Directive 2001/18/EC from Monsanto.
-  EFSA, 2004b. Opinion of the Scientific Panel on genetically modified organisms (GMO) on a request from the Commission related to the safety of foods and food ingredients derived from insectprotected genetically modified maize MON 863 and MON 863 x MON 810, for which a request for placing on the market was submitted under Article 4 of the Novel Food Regulation (EC) No 258/97 by Monsanto.
-  EFSA, 2007a. EFSA review of statistical analyses conducted for the assessment of the MON 863 90- day rat feeding study. EFSA, 2007b. Statement on the analysis of data from a 90-day rat feeding study with MON 863 maize by the Scientific Panel on genetically modified organisms (GMO).
-  EFSA, 2008. Updated guidance document for the risk assessment of genetically modified plants and derived food and feed. Annex A. EFSA, 2009a. Statistical considerations for the safety evaluation of GMOs.
-  EFSA, 2009b. Applications (references EFSA-GMO-NL-2005-22, EFSA-GMO-RX-NK603) for the placing on the market of the genetically modified glyphosate tolerant maize NK603 for cultivation, food and feed uses, import and processing and for renewal of the authorisation of maize NK603 as existing products, both under Regulation (EC) No 1829/2003 from Monsanto.
-  EFSA, 2009c. Applications (EFSA-GMO-RX-MON810) for renewal of authorisation for the continued marketing of (1) existing food and food ingredients produced from genetically modified insect resistant maize MON810; (2) feed consisting of and/or containing maize MON810, including the use of seed for cultivation; and of (3) food and feed additives, and feed materials produced from maize MON810, all under Regulation (EC) No 1829/2003 from Monsanto.
-  Seralini, G.E., Cellier D., de Vendômois J.S. 2007. New analysis of a rat feeding study with a genetically modified maize reveals signs of hepatorenal toxicity. Arch. Environ. Contam.  Toxicol., 52: 596-602.

Thursday, February 4, 2010

More Mr. Nice Guy - While nukes proliferate, the Federal President fiddles

More Mr. Nice Guy. By John Bolton

In his lengthy State of the Union address, President Obama was brief on national security issues, which he squeezed in toward the end. International terrorism, wars in Iraq and Afghanistan, and even America’s relief efforts in Haiti all flashed past in bullet-point mentions. On Iraq and Afghanistan, Obama emphasized neither victory nor determination, but merely the early withdrawal of U.S. forces from both. His once vaunted Middle East peace process didn’t make the cut.

Nonetheless, during this windshield tour of the world, the president found time to opine more explicitly than ever before that reducing America’s nuclear weapons and delivery systems will temper the global threat of proliferation. Obama boasted that “the United States and Russia are completing negotiations on the farthest-reaching arms control treaty in nearly two decades” and that he is trying to secure “all vulnerable nuclear materials around the world in four years, so that they never fall into the hands of terrorists.”

Then came Obama’s critical linkage: “These diplomatic efforts have also strengthened our hand in dealing with those nations that insist on violating international agreements in pursuit of nuclear weapons.” Obama described the increasing “isolation” of both North Korea and Iran, the two most conspicuous—but far from the only—nuclear proliferators. He also mentioned the increased sanctions imposed on Pyongyang after its second nuclear test in 2009 and the “growing consequences” he says Iran will face because of his policies.

In fact, reducing our nuclear -arsenal will not somehow persuade Iran and North Korea to alter their behavior or encourage others to apply more pressure on them to do so. Obama’s remarks reflect a complete misreading of strategic realities.

We have no need for further arms control treaties with Russia, especially ones that reduce our nuclear and delivery capabilities to Moscow’s economically forced low levels. We have international obligations, moreover, that Russia does not, requiring our nuclear umbrella to afford protection to friends and allies worldwide. Obama’s policy artificially inflates Russian influence and, depending on the final agreement, will likely reduce our nuclear and strategic delivery capabilities dangerously and unnecessarily. (Securing “loose” nuclear materials internationally has long been a bipartisan goal, properly so. Obama said nothing new on that score.) Meanwhile, Obama is considering treaty restrictions on our missile defense capabilities more damaging than his own previous unilateral reductions.

What warrants close attention is the jarring naïveté of arguing that reducing our capabilities will inhibit nuclear proliferators. That would certainly surprise Tehran and Pyongyang. Obama’s insistence that the evil-doers are “violating international agreements” is also startling, as if this were of equal importance with the proliferation itself.

The premise underlying these assertions may well be found in Obama’s smug earlier comment that we should “put aside the schoolyard taunts about who is tough.  .  .  .  Let’s leave behind the fear and division.” By reducing to the level of wayward boys the debates over whether his policies are making us more or less secure, Obama reveals a deep disdain for the decades of strategic thinking that kept America safe during the Cold War and afterwards. Even more pertinent, Obama’s indifference and scorn for real threats are chilling auguries of what the next three years may hold.

Obama has now explicitly rejected the idea that U.S. weakness is provocative, arguing instead that weakness will convince Tehran and Pyongyang to do the opposite of what they have been resolutely doing for decades—vigorously pursuing their nuclear and missile programs. Obama’s first year amply demonstrates that his approach will do nothing even to retard, let alone stop, Iran and North Korea.

Neither Bush nor Obama administration efforts toward international sanctions have had any measurable impact. The first Security Council sanctions on North Korea after its ballistic missile and nuclear weapons tests in 2006 did not stop Pyongyang from conducting further missile launches and a second nuclear detonation in 2009. Nor have the measures imposed after that second test, about which Obama boasted, impaired the North’s nuclear program or even brought Pyongyang back to the risible Six-Party Talks. Three sets of Security Council restrictions against Iran have only glancingly affected Tehran’s nuclear program, and the Obama administration’s threats of “crippling sanctions” have disappeared along with last year’s series of “deadlines” that Iran purportedly faced. In response, Tehran’s authoritarianism and belligerence have only increased.

With his counterproliferation strategies, such as they were, in disarray, Obama now pins his hopes on moral suasion, which has never influenced Iran, North Korea, or any other determined proliferator. Perhaps it would have been better had the president’s speech not mentioned national security at all.

John Bolton, former U.S. ambassador to the United Nations, is the author of Surrender Is Not an Option.

Obama vs. Holder

Obama vs. Holder. By Stephen F. Hayes

Tuesday, February 2, 2010

More Nuance Needed in Bank Regulations

More Nuance Needed in Bank Regulations. By Douglas J. Elliott
Brookings, January 22, 2010

January 22, 2010 — On the day President Barack Obama announced his new banking reform proposals, Reuters carried a story that Treasury Secretary Timothy Geithner had privately expressed reservations about the plan. Having had time to digest it, I can see why.

One of the key parts of this plan is a proposal to limit banks' "proprietary investments." Traditionally, banks took in deposits and put the money to work by lending it out and also by holding a substantial amount of fairly safe financial investments that could be readily sold if cash was needed quickly. Over time, banks have substantially increased the level of investments they held primarily for their higher expected returns and managed them as proprietary investments. They also ramped up the extent to which they traded in and out of securities opportunistically. Banks have also created or invested in external hedge funds for similar purposes, as well as to earn fees from managing the hedge funds.

The argument for limiting proprietary investments is essentially that cheap depositor funds, and other federal support, should not support gambling in the markets. The administration also cited the potential for conflicts of interest when a bank is both working with customers and making its own investments.

But the plan to limit proprietary investments is problematic for a number of reasons. It is so vague that we may find that the eventual details are downright harmful to the economy. In addition, the proposal lacks the subtlety and balance that underlay the administration's earlier financial reform proposals. Previously Obama and his team struck a good balance between the need for regulation and the benefits of letting financial markets work to find the most efficient solutions on their own. Thursday's proposals forbid activities outright, rather than providing appropriate incentives, disincentives and protections.

There is a clear appeal to keeping banks from taking undue investment risks. On the surface, it would appear fairly clear-cut that they ought not to have major proprietary investment positions. However, the issue becomes far more complicated and less clear as one examines it in more detail.

First, it is hard to tell the difference between traditional investment activity, which is a necessary part of banking, and proprietary investments, which are purely discretionary. Banks need to hold significant investment positions as part of their liquidity management. It is in everyone's interest for the return on those investments to be maximized, within acceptable risk limits, since more profitable banks are stronger and less likely to need a taxpayer bailout. It is important not to throw the baby out with the bath water.

Second, banks have long conducted trading activities to serve their clients in which it is often necessary to buy positions from sellers before the bank has an end-buyer. This brings trading risk, since the banks own the position for a time. It was a natural next step to allow the expert traders at the banks to take positions on a longer-term basis when they sensed that the market was moving in one direction. It is not always easy to distinguish these types of trades from ones motivated purely by customer demand.

Third, these investment activities should be unusually profitable for banks on average. They already have the traders and equipment in place, so the additional cost is low. Also, a great deal of information flows through the largest banks that can legitimately be shared. The insight gained from this provides a significant market advantage. Again, it is generally good public policy for banks to engage in profitable activities.

The key issue is to determine when the risk of proprietary investing exceeds the gain. The administration appears to have suddenly decided it is always too risky no matter what the circumstances.

I believe the situation is more nuanced; regulators ought to set limitations on proprietary investments and create capital requirements that are tough enough to hold the risk to the public to a very low level. Unfortunately, banking, like life, is not black and white.

Restricting Bank Activities

Restricting Bank Activities. By Douglas J. Elliott
Brookings, January 21, 2010

January 21, 2010 — President Obama has proposed various measures to restrict the size and scope of activity of the nation’s largest banks. These proposals are broadly in line with ideas being pushed by former Federal Reserve Chairman Paul Volcker and were announced in conjunction with a meeting between Volcker and the president. The key proposals all appear to require legislation and therefore are likely to undergo modification as a result of negotiations in Congress.

As this brief paper will hopefully make clear, the issues being addressed are complicated. This is a classic example of the devil being in the details and many of those details are simply unavailable. My own initial reaction is concern that the administration may be over-reacting to the risks it is trying to address, but it may be that further refinement of the proposals will address my concerns.

The biggest news comes from the president’s proposals to restrict proprietary trading and investments at the banks. Traditionally, banks took in deposits and put the money to work by lending it out and also by holding a substantial amount of fairly safe financial investments. These investments were held primarily because they provided more liquidity than loans, since they could be readily sold if needed, unlike loans. Sometimes investments were held because they would provide an unusually high return, but this was less common. Over the last couple of decades banks have substantially increased the level of investments that they held primarily for their higher expected returns and have ramped up the extent to which they traded in and out of securities opportunistically. Most of this activity is now done in units devoted to such “proprietary trading” where the bank’s own funds are invested in search of excess returns. Banks have also created or invested in external hedge funds for similar purposes, sometimes linked to an ability to earn fees from external investors for managing the hedge fund.

Many of the losses incurred by banks in the recent crisis occurred in their proprietary investment and trading books, although banks certainly lost money in more traditional ways as well. (For example, the mid-sized and smaller banks that are currently failing because of imprudent commercial real estate loans generally made their mistakes in very traditional ways. Larger banks are also losing a great deal of money on parts of their traditional lending activities, such as residential mortgage loans.) Chairman Volcker and a number of other observers have called for a limitation on the ability of banks to benefit from federally insured deposits, and the traditional liquidity supports provided by the Fed, if they are also going to do a significant volume of proprietary investment. The argument essentially is that cheap depositor funds should not be used to gamble in the financial markets.

The president proposes to essentially eliminate proprietary investments and ownership of hedge funds by banks. In addition to the risk management concerns, the administration has also cited the potential for conflicts of interest when a bank is both working with customers and making its own investments.

There is a clear appeal to keeping banks that benefit from deposit insurance and other public support, including potential taxpayer rescues, from taking undue investment risks. On the surface, it would appear fairly clearcut that they ought not to have major proprietary trading positions. However, the issue becomes far more complicated and less clear as one examines it.

First, it is harder than one might think to tell the difference between traditional investment activity, which is a necessary part of banking, and proprietary investments which are purely discretionary. Banks need to hold significant investment positions as part of their liquidity management and it has also generally been considered reasonable to invest the capital supplied by the bank’s shareholders into financial instruments. It is in everyone’s interest for the return on those investments to be maximized, within acceptable risk levels, since more profitable banks are stronger and in a better position to serve their customers. Part of that profit maximization comes from allowing banks to trade in and out of their investment positions as their situation changes or as they see market opportunities or threats. Therefore, it is somewhat difficult to draw a bright line between “proprietary investments” and traditional liquidity management activities. It is also hard to distinguish between investment and trading, since a significant amount of transactional activity can make sense even in a book that is essentially held for liquidity management purposes.

Second, banks have long been allowed to conduct certain trading activities to serve their clients. This is a relatively low risk business to the extent that it consists of trying to match buyers and sellers while earning a small spread for acting as the intermediary. It is often necessary for banks to buy positions from sellers before they have an end-buyer on the other side, in order to provide good service. This brings trading risk, since it is possible that they are not able to find that end-buyer at the price that they themselves paid. The need for these trading activities led banks to employ large numbers of in-house traders who developed substantial expertise. It was a natural next step to allow them to take certain positions on a somewhat longer-term basis when they could sense that the market was going to be moving in one direction or the other. It would not always be easy to distinguish these types of trades from ones that have a purer customer-based motive. Nor is it clear that we would want banks to give up the potential profits from the insights they gain through their general market activities.

Third, there is reason to believe that trading and investment activities should be unusually profitable for banks on average. The infrastructure they use for proprietary investments is generally already in place due to the need to hold large investment portfolios and to serve customers, therefore the marginal cost of adding proprietary investment activity can be low. In addition, a great deal of information flows through the largest banks. Some of this must be held confidential and cannot be shared even within the firm, but much of it can legitimately be shared. The insight gained from these information flows adds up to a significant market advantage that should yield excess returns on average. Again, all else equal, it is good public policy for the banks to engage in profitable activities that will make them stronger.

The key issue, therefore, is to determine when the risk created by proprietary investing exceeds the gain from allowing banks to engage in a generally quite profitable activity. Some observers clearly believe that proprietary investment almost always creates too much risk to the public. It appears that the administration is coming out on that side after a long period in which it had not placed major emphasis on this issue. My own view is that the situation is more nuanced and that regulators ought to have the ability to set limitations on proprietary investment and to set capital requirements for these activities that are high enough to hold the risk to the public to a very low level. Capital requirements can be quite effective as a risk management tool. At the extreme, a 100% capital requirement would mean that all the investment funds could be lost and it would not eat into any of the capital being used to back the rest of the bank’s activities.

The president also proposed that bank regulators be given the power to limit the size of any bank if its scale appears to create undue risk to the financial system. In particular, he proposed that the limits on deposit market share that already exist be extended to include all liabilities. This appears to be consistent with powers already incorporated into the financial regulatory reform bill that passed the House last year, although the president’s emphasis may increase the chance of those provisions surviving Congressional negotiations and even perhaps the probability of those powers being exercised by regulators in practice. If these provisions are included in the final legislation, it will be important to see whether the wording of the law tips the scales towards or away from their actual use. For example, limitations could be negotiated that would narrow the conditions under which regulators could take such an action. Alternatively, the law could provide a presumption that any bank over a certain size would be too big. There would also be a myriad of technical details surrounding how size would be measured. Banks might, for example, be able to able to slim down by moving significant amounts of assets into related entities or securitizing them out to unrelated parties while retaining some stake.

I am concerned, as a general matter, about arbitrarily limiting the size of the banks, since our modern, complicated, global economy demands that the U.S. have at least a few banks capable of providing a very wide range of services each on a large enough scale to be efficient. However, there certainly may be circumstances in which regulators ought to push a bank or banks to be smaller in general or smaller in certain activities. The question is how to balance the considerations and avoid arbitrary limits or decisions.

Defining Deficits Down

Defining Deficits Down. By Isabel V. Sawhill
Brookings, January 29, 2010

January 29, 2010 — When the president submits his budget on February 1, there will be a lot of hand-wringing about the possible economic fallout from a virtually unprecedented accumulation of debt. A long string of deficits out into the future will increase our dependence on foreign lenders, threaten the recovery if borrowers begin to demand higher interest rates, burden taxpayers with the costs of servicing the debt, and leave our children with a less prosperous future. Although these economic consequences are bad enough, the effects on public confidence in their government are even worse. Paralysis in the face of such dire warnings tells the public that their government is not working, undermines trust in our political institutions, and leads to more cynicism about the entire process, with ramifications that go far beyond the fiscal problem itself. Moreover the problem is so dire now that instead of doubling down on our efforts to do something we have moved the goal posts and redefined our deficit reduction goals. Although this may simply reflect the depth of the hole we are in and the difficulty of digging our way out, it may also shift public perceptions toward too ready acceptance of current reality and its associated dangers.

In the past there were bipartisan efforts to deal with deficits that were far smaller than those currently projected. Such efforts were grounded in a common belief that spending beyond one’s means was imprudent, even morally wrong. The goal for most of the pre World War II years was simple: an annually balanced budget. This meant that spending was cut and taxes raised even when the economy was depressed as in the 1930s. Following World War II, economists began to argue that the goal should be amended to allow deficit spending during recessions as long as that was offset by surpluses during periods of full employment. By the 1980s, this slightly amended goal was still extant and enshrined, for example, in the Gramm-Rudman-Hollings bill that called for a balanced budget by 1991. And when Ross Perot campaigned in 1992 on the need for a balanced budget, and won 19 percent of the vote, Clinton responded by working hard throughout his two terms to get to balance. The decade ended with a surplus of $236 billion in the federal budget. Fast forward to this year, and the goal has shifted from balancing the budget to keeping deficits below 3 percent of GDP in the president’s budget. That would mean accepting a deficit of over $400 billion (in today’s dollars) as a goal. However, even this much more modest goal now appears impossible to reach.

The current administration will be criticized for moving the goal posts on deficit reduction and for doing far too little to restore fiscal balance. This year’s budget includes a freeze on non-security discretionary spending, support for pay-go rules, and a presidentially appointed deficit-reduction commission. These are good but totally insufficient steps. The spending freeze will affect only a tiny slice of the budget; the pay-go rules will make it more difficult for Congress to dig the hole deeper but won’t affect currently projected red ink; and the commission will likely be a paper tiger. In short, these proposals will still leave us with unsustainable deficits as far as the eye can see. Granted current deficits were largely inherited and have been further ballooned by the need to fight the current downturn, leaving the current administration with a herculean task. But it is depressing to discover that we can no long even aspire to balance the budget once the recession is over.

The late Senator Moynihan used to talk about defining deviancy down by which he meant that new norms get established in response to bad behavior. The nation’s fiscal behavior is now so bad that I fear we will soon accept a degree of fiscal profligacy that would have been unthinkable in earlier times. Shame on all of our elected officials, past and present, who have allowed this to happen.

How to Make a Weak Economy Worse - FDR's war against business showed that a president must choose between retribution and recovery

How to Make a Weak Economy Worse. By AMITY SHLAES
FDR's war against business showed that a president must choose between retribution and recovery.
WSJ, Feb 02, 2010

You get the feeling President Obama is girding for battle with the financial sector. In last week's State of the Union address, he promised to regulate the industry. On Jan. 21, he was blunter, warning that he would not let companies that enjoyed "soaring profits and obscene bonuses" block his financial reforms. "If these folks want a fight," he said, "it's a fight I'm ready to have."

This declaration of war echoes that of Franklin Delano Roosevelt. In 1936, late in his campaign for a second presidential term, FDR spoke of the challenges of "business and financial monopoly, speculation, reckless banking." Wall Streeters and businessmen hated him, he said, adding that "I welcome their hatred."

Then Roosevelt escalated: "I should like to have it said of my first administration that in it the forces of selfishness and the lust for power met their match. I should like to have it said of my second administration that in it these forces met their master."

Mr. Obama might want to stick to a moderate approach. FDR's war against business played to the crowd, but it hurt the economy. While monetary policies impeded recovery in the late 1930s, it was the administration's assault on companies and capital that ensured the Depression's duration.

Roosevelt had initially opted for safety and picked relatively moderate advisers. His first Treasury Secretary, William Woodin, was a railroad executive. Roosevelt also kept over a Hoover-era official, Jesse Jones, at the TARP of the day, the Reconstruction Finance Corp. James Warburg, the son of Wall Street banker Paul Warburg, also joined the team.

In the crucial days before March 5, 1933, when FDR declared a "bank holiday" to halt the bank run, New Dealers worked with Republicans to resolve the financial crisis. When it came to reforming Wall Street, they were likewise measured. Yes, they created the Securities and Exchange Commission. But their regulation seemed designed to serve markets, not stamp them out. At least mostly.

Though there was nothing establishment about the centerpiece of the early New Deal, the National Recovery Administration, it was friendly to big business. Indeed, too much so. Under the NRA, the largest players in each industrial sector were judged too big to fail not because their failure would create systemic financial risk—the argument for banks today—but rather in the faith that firms of such scale could serve as engines of recovery.

And Roosevelt, like Presidents Obama and Bush, dumped billions in cash onto the country. There was, not surprisingly, a Roosevelt market rally, just as there has been an Obama rally.

But complete recovery proved elusive. The public spending programs had less effect than hoped. Smaller firms complained, accurately, that the NRA's minimum wages and limits on hours disadvantaged them. Unemployment was still high. FDR knew he could not keep asking Congress to authorize enormous outlays forever.

Frustrated, the president shifted to retribution. By 1935, FDR decided that firms, especially big firms, were impeding recovery. They must now redeem themselves and save the economy by sacrificing—or else.

The attacks started with taxes. In 1935, well before the "hatred" speech, FDR led Congress in passaging a law that replaced a flat rate on corporate income with a graduated rate—itself a penalty on larger firms. Personal income taxes went up, as did other rates. In 1936 FDR signed into law the undistributed profits tax, which aimed to force reluctant firms to disgorge cash as dividends or by paying higher wages. This levy too was graduated, with a top rate of 27%.

The 1935 Wagner Act was a tiger that makes today's union law look like a pussycat. It favored unions over companies in nearly every way, including institutionalizing the closed shop. And after Roosevelt's landslide victory in 1936, the closed shop and the sit-down strike stole thousands of productive workdays from companies, punishing earnings and limiting ability to hire.

Of particular relevance today was Roosevelt's switch on antitrust policy. The large companies once rewarded by the NRA now became targets.

The final front of the war was utilities, the country's most hopeful industry. FDR's 1935 law, the Public Utilities Holding Company Act, made it so difficult for private-sector firms in this industry to raise capital that it was called a death sentence.

The result of it all was the Depression within the Depression of 1937 and 1938, when industrial production plummeted and unemployment climbed back into the higher teens. Even John Maynard Keynes chided FDR for his attitude about businessmen: "It is a mistake to think they are more immoral than politicians."

Among themselves, the New Dealers acknowledged failure. FDR's second Treasury Secretary, Henry Morgenthau, eventually determined that the problem was lack of what he labeled "business confidence." Late in the decade, Morgenthau dared to call for tax cuts. He even placed a sign on his desk asking, "Does it contribute to recovery?" Roosevelt told him the sign was "very stupid."

Ultimately the war abroad required FDR to give up his war at home. Now the same industries that had been under prosecution were at the War Production Board, signing contracts. Scholars have argued that wartime spending ended the Depression. But the truce with business played an important role.

The 1930s story suggests not that any individual reform is wrong per se. It reminds us rather that frustrated presidents are inconsistent, that antibusiness policies are cumulative, and that hostility yields more damage than benefit. Presidents can choose between retribution and recovery. They cannot have both.

Miss Shlaes, a senior fellow in economic history at the Council on Foreign Relations, is author of "The Forgotten Man: A New History of the Great Depression" (HarperCollins, 2007).