Page 1 of 4 Volcker - time for real change
By Henry CK Liu
United States President Barack Obama announced on January 21 that he had
accepted the advice of two prominent Republican big names in finance in an
apparent renewed effort to appeal for bipartisan support. The move came two
days after the Democrats' disastrous election loss, to a mostly unknown
Republican candidate, of a senate seat long held by the late Edward Kennedy and
critical for maintaining a filibuster-proof majority.
The president told the nation on television: "I just had a very productive
meeting with two members of my Economic Recovery Advisory Board: Paul Volcker,
who's the former chair of the Federal Reserve Board; and Bill Donaldson,
previously the head of the SEC [Securities and Exchange Commission]. And I
appreciate the counsel of these two leaders and the board that they've offered
as we have dealt with a broad array of very difficult economic challenges."
Incorporating in his announcement a subtle remainder of the responsibility of
the previous Republican administration for the sad state of the US economy,
Obama, after one year in office, pointed out that "over the past two years more
than seven million Americans have lost their jobs in the deepest recession our
country has known in generations".
Total US job loss in 2008 under the previous George W Bush administration was
2.6 million, leaving a job loss figure of some 4.4 million jobs by Obama's own
account under his watch so far, even after unprecedented massive stimulus
spending by both administrations. And by all accounts, the bottom of
unemployment is still nowhere in sight.
It is not a good record for the Democrats with which to go into the mid-term
election in November. The odds are that the Democrats stand to lose majority
control of both houses unless the Obama administration can reverse rising
unemployment trends within the next 10 months.
The record of Obama's legislative achievement in his first year in office has
been dismal, even with his party controlling both houses of congress. There are
widespread complaints that the White House has yielded policy initiative to
congress. If the Democrats should lose control of congress after the mid-term
election, Obama will be in danger of being a lame-duck, one-term president
after only two years in office.
Thus it is not surprising to hear the president to say: "Rarely does a day go
by that I don't hear from folks who are hurting. And every day, we are working
to put our economy back on track and put America back to work. But even as we
dig our way out of this deep hole, it's important that we not lose sight of
what led us into this mess in the first place." Thus far, many voters are
concluding that the Obama economic team, instead of digging its way of out a
deep hole, has been digging deeper into a hole from which it will take the
economy even longer to get out of.
Obama reminds his listeners that "this economic crisis began as a financial
crisis, when banks and financial institutions took huge, reckless risks in
pursuit of quick profits and massive bonuses. When the dust settled, and this
binge of irresponsibility was over, several of the world's oldest and largest
financial institutions had collapsed, or were on the verge of doing so. Markets
plummeted, credit dried up, and jobs were vanishing by the hundreds of
thousands each month. We were on the precipice of a second Great Depression."
The president then makes a controversial claim by saying: "To avoid this
calamity, the American people - who were already struggling in their own right
- were forced to rescue financial firms facing crises largely of their own
creation. And that rescue, undertaken by the previous administration, was
deeply offensive but it was a necessary thing to do, and it succeeded in
stabilizing the financial system and helping to avert that depression."
The fact is that, as the crisis exploded, the American people were not
consulted on the decision to rescue the wayward financial firms, or on the most
effective level of government intervention to limit the potential damage caused
by the financial sector to the economy.
The rescue decisions were make behind closed doors by the crony financial elite
and their paid advisors, the very same people who had caused the crisis and
whose priority interest was their collective survival on the premise that their
demise was also the death knell of the economy. It was not surprising that the
government intervention measures were skewed more toward rescuing the wayward
financial institutions than to the victimized public.
In fact, Treasury Secretary Timothy Geithner of the Obama administration, when
president of the New York Federal Reserve Bank in September 2008, urged AIG to
limit disclosure of its deal to buy out derivative trading partners at 100
cents on the dollar when the Federal Reserve sent $182.3 billion in taxpayer
bailout money to AIG. This request to withhold material information from the
market is of dubious legality, but what was worse was that much of this money
was used to meet collateral calls from big banks that had bought AIG credit
default swaps, merely to make the banks whole - ie recover all their investment
AIG had earlier resisted handing over more cash collateral to the banks. But
once the government, through Geithner, took charge of AIG, the cash flowed
freely and quietly to these bank counterparties with no questions asked of the
banks if they should accept a conventional haircut - that is, receive less than
100 cents on the dollar owed. The Fed-rescued AIG ultimately bought the
underlying securities at par, much more than the counterparties might have
received from a bankrupt AIG, but even a healthy AIG would never have handed
over so much cash in the midst of a panic in which cash was king.
Yet when asked directly by the inspector general for the Troubled Asset Relief
Program (TARP) why he opted to buy out the counterparties at par, Geithner said
"the financial condition of the counterparties was not a relevant factor". The
reply was inoperative. If counterparty financial conditions are not relevant
factors of systemic risk, there is no need for derivative regulation reform.
Taxpayers still are kept in the dark about Geithner's view of the systemic risk
posed by AIG counterparties, which included Goldman Sachs. If the financial
condition of AIG counterparties posed systemic consequences, why not disclose
their identities with the explanation that they were all getting a deal to
bolster liquidity and allow them to resume lending? That is exactly what
regulators did a month earlier in October 2008 by naming recipients of TARP
As the dust settles, there does not seem to be supportive evidence that the
threat of systemic risk posed by an AIG failure could be established by
vigorous mathematics based on solid data. The AIG's sweet deal raises several
issues: 1. There is no evidence except scare-tactic rationalization that letting
big financial institutions fail, though no doubt painful to many, would be the
end of financial life on Earth. 2. If systemic failure is the cause of the financial crisis, then a
collapse of the system is the only effective way towards reform. Spending
future wealth to bandage over fatal wounds to preserve a failing system will
only obscure the need for true reform. This is what has happened in 2009. The
economy is still in danger of dying from financial gangrene.
3. There is no evidence that the panic bailout has saved the system. The
amount of pain remains the same, if not greater, with the need to pay for the
wasted bailout down the road. The only difference is that, with the bailout,
the pain will be stretched out for decades more, with additional pain in the
form of interest cost to be paid by future generations and continuing loss of
purchasing power of the dollar. In time, the pain will numb expectation to
appear normal. 4. Eventually, we may still have to let the insolvent institutions fail,
even having thrown good money after bad. This is because these institutions did
not fail from lack of money; rather, they failed because cheap money was too
readily available. 5. The banking system has not been saved, only the too-big-to-fail banks
were saved. Large numbers of smaller community banks have gone under and many
more will go under. A healthy banking system cannot be one with only five super
banks. 6. The challenge is to save the financial system, not the wayward
financial institutions that had destroyed the system. Avoidance of pain is not
an effective curative protocol.
The president claims in his announcement that, "Since that time, over the past
year, my administration has recovered most of what the federal government
provided to banks. And last week, I proposed a fee to be paid by the largest
financial firms in order to recover every last dime. But that's not all we have
to do. We have to enact common-sense reforms that will protect American
taxpayers - and the American economy - from future crises as well."
As of the end of December 2009, government data indicate the total bailout
money outstanding was $337.5 billion, the losses booked from the bailouts
staying at $9 billion. The Treasury released updated estimate for ultimate
losses from TARP at $61.1 billion, with half the amount each related to AIG and
Auto Companies bailouts. It also forecast that other parts of the TARP will end
up making money for taxpayers. Put it all together, and the final estimated
loss from the bailout's first full year is about $41.6 billion.
The president admits that "[F]or while the financial system is far stronger
today than it was one year ago, it's still operating under the same rules that
led to its near collapse. These are rules that allowed firms to act contrary to
the interests of customers; to conceal their exposure to debt through complex
financial dealings; to benefit from taxpayer-insured deposits while making
speculative investments; and to take on risks so vast that they posed threats
to the entire system."
Addressing the "too big to fail” syndrome, the president said, "That's why we
are seeking reforms to protect consumers; we intend to close loopholes that
allowed big financial firms to trade risky financial products like credit
defaults swaps and other derivatives without oversight; to identify system-wide
risks that could cause a meltdown; to strengthen capital and liquidity
requirements to make the system more stable; and to ensure that the failure of
any large firm does not take the entire economy down with it. Never again will
the American taxpayer be held hostage by a bank that is 'too big to fail'."
As part of the administration's proposal to congress for legislation to put
"limits on the risks major financial firms can take", the president proposes
two additional reforms to strengthen the financial system while preventing
future crises: 1. Banks will no longer be allowed "to stray too far from their central
mission of serving their customers" as they were in recent years, as "too many
financial firms have put taxpayer money at risk by operating hedge funds and
private equity funds and making riskier investments to reap a quick reward. And
these firms have taken these risks while benefiting from special financial
privileges that are reserved only for banks. ... When banks benefit from the
safety net that taxpayers provide - which includes lower-cost capital - it is
not appropriate for them to turn around and use that cheap money to trade for
profit. And that is especially true when this kind of trading often puts banks
in direct conflict with their customers' interests. …
" ... It's for these reasons that [the president is] proposing a simple and
common-sense reform, called the "Volcker Rule”. Banks will no longer be allowed
to own, invest, or sponsor hedge funds, private equity funds, or proprietary
trading operations for their own profit, unrelated to serving their customers.
If financial firms want to trade for profit, that's something they're free to
do. Indeed, doing so - responsibly - is a good thing for the markets and the
economy. But these firms should not be allowed to run these hedge funds and
private equities funds while running a bank backed by the American people."
2. "In addition, as part of our efforts to protect against future
crises, I'm also proposing that we prevent the further consolidation of our
financial system. There has long been a deposit cap in place to guard against
too much risk being concentrated in a single bank. The same principle should
apply to wider forms of funding employed by large financial institutions in
today's economy. The American people will not be served by a financial system
that comprises just a few massive firms. That's not good for consumers; it's
not good for the economy. And through this policy, that is an outcome we will