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Risky Business – Paul Krugman on Wall Street Regulation

May 14, 2012   ·   0 Comments

Source: NYTX

By Marie Burns:

In today’s New York Times, economist Paul Krugman joins the chorus of experts warning against allowing too-big-to-fail banks to engage in risky business, especially with other people’s money.

The occasion for Krugman’s warning, of course, is “JPMorgan’s shock announcement that it somehow managed to lose $2 billion in a failed bit of financial wheeling-dealing.” What exactly did JP Morgan do? Naturally, that’s complicated. David Henry and Douwe Miedema of Reuters reported the short answer last Friday: JPMorgan’s CEO Jamie Dimon

said the $2 billion in losses could rise by a further $1 billion, and acknowledged they were linked to a London-based credit trader Bruno Iksil. Nicknamed the ‘London Whale’, Iksil amassed an outsized position which hedge funds bet against, according to a report in The Wall Street Journal in April. The exact nature of the trading loss is still unclear, although sources said a host of asset managers, arbitrageurs and hedge funds were on the other side of the bet, viewing it as good value and a effective way to insure portions of their portfolio.

Heidi Moore of Marketplace has an excellent explanation of how mystery-man Iksil “messed up” a “giant bet on U.S. corporate bonds” and “used derivatives to do it.” The figure that Dimon mentions is $2 billion, or $3 billion if you add the odd billion he says his bank could still lose on the London Whale’s bad bet. But the real number is much scarier: Moore notes that according to Bloomberg News, which first broke the story of Iksil’s trading in early April, the JPMorgan Chase bet was worth $100 billion. Iksil was betting on low-risk – good-quality – bonds, so what could possibly go wrong? Well, Iksil had such confidence – overconfidence, as it turns out – in these bonds that he didn’t do what risk managers normally do: he didn’t buy protection — in the form of credit default swaps — against the risk of the bonds going south. In fact, instead of buying credit-default swaps, “he sold them,” Moore writes. Meanwhile, Iksil’s competition – “hedge funds and other traders … took the other side of the bet” and “they also bought protection on the underlying corporate bonds to influence the value of those.” When some in the financial media took note of Iksil’s massive market position, Jamie Dimon called the heightened interest “a complete tempest in a teapot…. Every bank has a major portfolio. Obviously it’s a big portfolio; we’re a large company… It’s our job to invest our portfolio wisely and intelligently.” Well, they didn’t do their job. The Whale got beached.

If you think Iksil’s shenanigans sound a lot like the gambling in high-risk mortgages that led to the financial crisis of 2008, you would be right. Gambling is gambling. Somebody loses. And when the loser is a too-big-to-fail bank, you could be the biggest loser. The money Iksil gambled away was yours if you have a bank account at JPMorgan. Even if you don’t, in a worst-case scenario, the taxpayer could get stuck again bailing out yet another big bank. The FDIC, which insures depositors against losses, can run a tab with the U.S. Treasury. As it turns out, JPMorgan Chase is so big that it can absorb a $3 billion loss. As Jamie Dimon told David Gregory on “Meet the Press” yesterday, his bank is “very strong.” So despite the huge loss, the taxpayer is off the hook here.

You might wonder how JPMorgan Chase could have made these risky trades, what with the new financial regulations put in place following the 2008 meltdown. Wasn’t Dodd-Frank supposed to prevent this kind of trading? What about the Volcker Rule, which was specifically written to prevent banks from playing with other people’s money? Well, the Volcker Rule, which has grown from three pages to more than 300, has not been implemented yet. And no one has fought the Volcker Rule harder than Jamie Dimon. Since JP Morgan Chase was the one big bank that remained profitable through the 2008 crisis, other bankers have made him the designated hitter against the Volcker Rule: the person best qualified to pooh-pooh concerns that the banks don’t know how to handle money. Besides the efforts to bring around regulators, Dimon went on a little P.R. tour, which Michael de la Merced of the New York Times characterized as “Dimon vs. Volcker, the Television Series.” (The de la Merced report includes videos.) On April 4, 2012, Steven Gandel of CNN reported on Dimon’s letter to JP Morgan Chase shareholders. Dimon wrote

that he believed recently imposed banking regulations like Dodd-Frank was holding back JPMorgan and other banks’ ability to lend. Dimon quipped that when the history of the recovery from the financial crisis is written it will be titled ‘It Could Have Been Much Better.’ He seemed to lay most of the blame for that on Washington. Dimon’s biggest regulatory beef is with a requirement that will force JPMorgan and other large banks that are deemed ‘Systemically Important’ to hold as much as a third more capital than the minimum other banks have to hold to protect themselves against bad loans and other losses. He called the rule ‘contrived,’ and said that it would make the banks less diversified, not more so. Dimon said he also had problems with the Volcker rule, which limits banks’ ability to make risky trades, and with rules that govern derivatives, an area that JPMorgan is big in.

Dimon saw plenty wrong with regulators and other nosy parkers, and he expressed it more forcefully elsewhere. Jessica Pressler of New York magazine wrote recently,

Over the past few years, the JPMorgan CEO leveraged his position as America’s Least-Hated Banker to become a vocal critic of attempts to rein in Wall Street, and no one who has stood in his way has been spared: Not Tim Geithner, the treasury secretary Dimon calls ‘Timmy,’ who helped orchestrate [more-than-sweet] last-minute deals; not Fed Chairman Ben Bernanke, whose policies have allowed JPMorgan to borrow billions at absurdly low interest rates, and who Dimon recently ambushed with the suggestion he didn’t know what he was doing; not the ‘overpaid journalists’ who express skepticism at his desire to do what he wants with impunity; and especially not President Obama, whom he has childishly accused of ‘unfairly’ expecting bankers ‘to just bend over and take it.’

Nonetheless, Timmy came through for Dimon once again. Treasury officials and the Comptroller of the Currency (a Wall Street regulator) took the bankers’ side. So did the Federal Reserve, perhaps not so surprising since (a) the Fed work for the banks (the banks bankroll the Fed), and (b) Dimon sit on the New York Board. Elizabeth Warren and Eliot Spitzer have both called for Dimon to resign from the New York Fed. (In a letter I just received, Warren also calls for passage of a new Glass-Steagall Act, which would prevent big banks from “taking huge risks with people’s life savings – and then expecting taxpayer bailout.”)

All in all, Dimon’s (and others’) lobbying “efforts produced ‘a big enough loophole that a Mack truck could drive right through it,’ Senator Carl Levin, the Michigan Democrat who co-wrote the legislation that led to the Volcker Rule, said Friday….” In announcing the loss, Dimon tried to characterize it as one that would have been lawful under the Volcker rule anyway. But Phil Angelides, who headed the Financial Crisis Inquiry Commission, said, “I think the regulators need to go back and sharpen their pencils. The intent of the law was to stop insured depositories from doing propriety trading with this kind of risk profile.” Whatever Dimon calls it (he used the term “synthetic credit portfolio” which sounds a little like a cheap plastic wallet) Angelides says, “it sure looks like proprietary trading, which Dodd-Frank was designed to stop….” And Rep. Barney Frank (D-Mass.), who has an uncanny ability to put issues in perspective, was quick to remark that “JPMorgan has lost, in this one set of transactions, five times the amount they claim financial regulation is costing them.”

Still, as Krugman writes, the problem is much larger than a few failed super-bets, even ones taxpayers might have to cover:

… banking is and always has been subject to occasional destructive ‘panics,’ which can wreak havoc with the economy as a whole. Current right-wing mythology has it that bad banking is always the result of government intervention, whether from the Federal Reserve or meddling liberals in Congress. In fact, however, Gilded Age America – a land with minimal government and no Fed – was subject to panics roughly once every six years. And some of these panics inflicted major economic losses.

During the 1930s, the government established both deposit insurance and a system of bank regulation that “gave us half a century of relative financial stability,” Krugman writes.

But ever since the late 1970s, Congress has been repealing much of the regulatory structure and underfunding agencies while lackadaisical regulators – many of them travelers through the Washington-Wall Street revolving door – just can’t seem to find any serious cases of malfeasance. Even when they do, the “consequence” is apt to be a slap on the wrist, a small fine (by big bank standards) that the banks certainly consider a minor cost of doing business. As Gretchen Morgenson and Louise Story of the New York Times reported last summer, the S.E.C. and Justice Department even have adopted a banker-friendly system of leniency called “deferred prosecutorial agreements,” which allows banks to “self-report” fraud and other crimes (not to be confused with Mitt Romney’s plan to make life so miserable for immigrants they will “self-deport”). The banks’ get-out-of-jail-free card is, to a great extent, just a formalization of the lax practices these agencies already employed. We’ll get back to why this is.

With too little oversight, as Peter Eavis and Susanne Craig of the New York Times reminded us Friday,

… trading debacles happen with surprising regularity. Last year, losses at two big institutions rocked the financial world. MF Global went out of business after making an ill-timed bet on European debt. Before that, a UBS trader in London lost the firm $2.3 billion. The 2008 financial crisis was the result of major risk miscalculations that brought down several big financial institutions, including Bear Stearns, Lehman Brothers and the American International Group.

Krugman writes,

It’s clear, then, that we need to restore the sorts of safeguards that gave us a couple of generations without major banking panics. It’s clear, that is, to everyone except bankers and the politicians they bankroll – for now that they have been bailed out, the bankers would of course like to go back to business as usual. Did I mention that Wall Street is giving vast sums to Mitt Romney, who has promised to repeal recent financial reforms?

He is right, of course, but I do think Krugman is far too polite. Mitt Romney, for instance, has promised to repeal recent financial reforms, and he won’t say what – if anything – he would put in their place. Matt Viser and Tracy Jan of the Boston Globe wrote earlier this month,

Romney is pledging, if he is elected president, to repeal the Dodd-Frank financial regulations, a position favored by donors on Wall Street who have sent millions the candidate’s way. But he is nearly silent on how – without the regulation – he would prevent Wall Street from once again engaging in the risky practices that helped cause the 2008 financial crisis…. Romney’s campaign did not respond to a list of questions from the Globe about specific ways he would change the law.

But don’t think the problem rests only with Republicans. As Peter Boyer and Peter Schweitzer wrote in Newsweek last week: “Despite his populist posturing, the president has failed to pin a single top finance exec on criminal charges since the economic collapse. Are the banks too big to jail – or is Washington’s revolving door at to blame?” They follow the money to answer their own question.

Two months into his presidency, Obama summoned the titans of finance to the White House, where he told them, ‘My administration is the only thing between you and the pitchforks.’ … As it turned out, Obama apparently actually meant what he said at that White House meeting – his administration effectively would stand between Big Finance and anything like a severe accounting…. Financial-fraud prosecutions by the Department of Justice are at 20-year lows.

I think Obama’s fealty to Wall Street has been evident all along. Former Treasury Secretary and Wall Street honcho Robert Rubin was an influential advisor to Obama’s 2008 campaign. During the transition, it became clear as Obama rolled out one usual suspect after another as Cabinet nominees that he was not going to back the pitchfork carriers. Former Sen. Byron Dorgan (D-N.D.), a financial ethics hawk, told Obama, “You’ve picked the wrong people!” (I doubt the Tea Party would have had the impact it did had Obama & Co. marched a few fat cats perps in cuffs past the cameras. People were furious, and they were not entirely mistaken in aiming their pitchforks at Washington instead of at Wall Street, even though they chose the wrong targets – the Affordable Care Act, for instance – for the wrong reasons – “Obama is a socialist! And he’s black!”) As Boyer and Schweitzer point out, the revolving-door poster child is Attorney General Eric Holder, who approved those “deferred prosecutorial agreements” I mentioned earlier (the program actually began during the Bush Administration, and Holder continued it). Holder was a top Justice official under President Clinton, and from there he went to the law firm of Covington & Burling, where he co-chaired their notorious “elite white-collar defense unit.” Covington clients include JPMorgan Chase, Goldman Sachs, Citigroup, Bank of America, Wells Fargo, and Deutsche Bank, some of whom have matters before the Department of Justice. Holder’s co-chair at Covington & Burling: Lanny Breuer, who “was chosen to head the criminal division at Obama’s Justice.” How about that?

Boyer and Schweitzer outline a few of Obama’s smoke-and-mirrors tricks. Here’s one you may recall:

In November 2009, Attorney General Holder, with Treasury Secretary Timothy Geithner at his side, announced the creation of another special unit – the Financial Fraud Enforcement Task Force – that was similarly charged with investigating securities and mortgage fraud that contributed to the financial meltdown. Since its creation, that task force, which critics say was drastically under-resourced, has produced not a single conviction (or even indictment) of a major Wall Street player related to the financial disaster.

Glenn Greenwald complains, rightly I think, that

The worst part of it is all is that Obama is going to spend the next six months deceitfully parading around as some sort of populist hero standing up for ordinary Americans and the safety net against big business, and hordes of people who know how false that is will echo it as loudly and repeatedly as they can, tricking many people who don’t know better into believing it….

The prior decade witnessed the most egregious crimes imaginable by the nation’s most powerful actors: torture and warrantless eavesdropping from political officials (with the aid of corporate giants), and massive fraud from financial elites. None has been held accountable; the opposite is true: the Obama administration has steadfastly protected all of them…. America’s elites are virtually immune from the rule of law.

In the short run, Americans may be lucky that Wall Street moguls are mad at Obama, and are expressing their pique by holding their fat wallets close to their breasts. Maybe in retaliation, he’ll put a smidgen of substance behind his populist rhetoric. But in the long run, the only answer is campaign finance reform, something that cannot happen – without a Constitutional Amendment – as long as the Supreme Court remains in the hands of a conservative majority. And a Constitutional Amendment is a pipe dream.

In the meantime, it’s business as usual on Wall Street. Krugman remarks that, “For the moment Mr. Dimon seems chastened, even admitting that maybe the proponents of stronger regulation have a point.” This momentary display of humility will probably last all the way through tomorrow, when Dimon faces JPMorgan Chase’s annual shareholders’ meeting during which the shareholders will be asked to approve a $23 million annual compensation package for Dimon.

Krugman figures, “Wall Street to be back to its usual arrogance within weeks if not days.” I think so, too. I take my cue not from Krugman but from another fine opinion piece that appeared in Sunday’s New York Times: William Deresiewicz notes the percentage of “clinical psychopaths” working on Wall Street is ten times higher than in the general population. How does this personality type act? He exhibits “a lack of interest in and empathy for others and an ‘unparalleled capacity for lying, fabrication, and manipulation.’”

“Ethics in capitalism is purely optional, purely extrinsic,” Deresiewicz write.

To expect morality in the market is to commit a category error. Capitalist values are antithetical to Christian ones. (How the loudest Christians in our public life can also be the most bellicose proponents of an unbridled free market is a matter for their own consciences.) Capitalist values are also antithetical to democratic ones. Like Christian ethics, the principles of republican government require us to consider the interests of others. Capitalism, which entails the single-minded pursuit of profit, would have us believe that it’s every man for himself.

This isn’t news. It is as it has always been. It is ludicrous to even suggest Wall Street will self-regulate, even when it is ultimately in their best interest to do so. There is no appealing to the angels of their better natures, because such angels do not exist. The central purpose of government is to protect us from people acting against the public interest. Wall Street operates on the principle of self-interest. This is the underlying truth on which the government should approach everything related to American business and finance. If a capitalist can behave badly, he will. Count on it. Now that is a bet no one would hedge.

Marie Burns blogs at RealityChex.com

By marieburns

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