A New Volcker Rule for the Wayward US Financial Sector
 
By
Henry C.K. Liu
 
 
President Obama announced that he has accepted the advice of two prominent Republican big names in finance in an apparent renewed effort to appeal for bipartisan support on January 21, 2009, two days after the Democrats’ disastrous loss in a special election for a Senate Democratic seat critical for maintaining a filibuster proof majority long held by the late Edward Kennedy to a mostly unknown Republican candidate.
 
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. And I deeply 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, President 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 Bush administration was 2.6 million, leaving a job loss figure of some 4.4 million jobs by President 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 next 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 ten 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 complaint that the White House has yielded policy initiative to the Congrress. 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 that would take the economy longer to get out.
 
President 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 imploded, 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 door 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 toward rescuing the wayward financial institutions than the victimized public.
 
In fact, Treasury Secretary Geithner of the Obama administration, when as 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 Fed sent $182.3 billion in taxpayer bailout to AIG. This request of withholding material information from the market is of dubious legality enough, 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 unnecessarily.
 
AIG had earlier resisted handing over more cash collateral to the banks. But once the government through Mr. 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. 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, Mr. 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 capital injections.
 
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 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, will 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. Treasury released updated estimate for ultimate losses from Troubled Asset Relief Program (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 “For 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 avoid.”
 
The President then appeals for bipartisan support for his proposal as well as to financial industry leaders not to send “an army of industry lobbyists from Wall Street descending on Capitol Hill to try and block basic and common-sense rules of the road that would protect our economy and the American people. So if these folks want a fight, it’s a fight I’m ready to have. And my resolve is only strengthened when I see a return to old practices at some of the very firms fighting reform; and when I see soaring profits and obscene bonuses at some of the very firms claiming that they can’t lend more to small business, they can’t keep credit card rates low, they can’t pay a fee to refund taxpayers for the bailout without passing on the cost to shareholders or customers -- that’s the claims they’re making. It’s exactly this kind of irresponsibility that makes clear reform is necessary.”
 
A day later, On January 22, the Supreme Court in a 5-4 decision overruled two important precedents about First Amendment (free speech) rights of corporations to rule that the government may not ban political spending by corporations in candidate elections. The ruling will have immediate and major impact on the coming mid-term Congressional election in November, given that it came two days after the Democrats lost the 60-seat filibuster majority in the Senate by the loss of the Massachusetts seat of the late Senator Edward Kennedy. The Supreme Court is confusing money with speech. If the majority of the Court is concern about protecting free speech, it should call for equal rights protection in political spending by corporations to require the spender to also fund the cost of equal time for the opposition. Equal time is a well established practice in network television campaign coverage for candidates.
   
On the Website of New Deal 2.0, a project of the Roosevelt Institute, Randall Wray, Professor of Economics at the University of Missouri-Kansas City, Research Director with the Center for Full Employment and Price Stability and Senior Research Scholar at the Levy Economics Institute, praised President Obama for finally moving in the right direction, albeit only “in a baby step”.  However, Wray feels that the nature of this proposal seems to indicate that Obama still does not understand the scope of the problem. Wray lists what he believes to be more than mere quibbles: 

1. The financial bail-out was not needed and would do nothing to prevent another great depression. We had a liquidity crisis that could have been resolved in the normal way, through lending by the Fed without limit, to all financial institutions, and without collateral. That is how you end a liquidity crisis. But that has nothing to do with the Paulson/Rubin/Geithner plans that variously bought bad assets, injected capital, and provided guarantees — in an amount estimated above $20 trillion. None of that was necessary and none of it prevented collapse of the economic system. Banks are still massively insolvent. If we wanted to leave insolvent institutions open, all we had to do was to use forbearance. And, in truth, that is the only reason they are still open for business.  

Elsewhere, Wray and others have pointed out that such intervention measures embolden “moral hazard” to guarantee future recurrence of the same crisis as financial firm will operate with the confidence that government bailout is assured.

2. And of course, none of that had any benefit at all for Main Street. Indeed, we could have closed down the top 20 banks (responsible for almost all of the mess) with no impact on the economy. The only thing that has helped was the fiscal stimulus package. That will soon run out, and although it helped it was far too small. Obama has zero chance of getting more money for Main Street unless he can convince Congress and the public that he has changed his ways. The reforms he has announced fall short.

3. The financial system is not healthier today. Indeed, it is much more dangerous. The Bush and Obama administrations reacted to the crisis by encouraging and subsidizing consolidation of the sector in the hands of gargantuan and dangerously insolvent institutions. The sector is essentially run by a handful of rapacious institutions that have made out like bandits because of the crisis: Goldman, JP Morgan, Citi, Chase and Bank of America. All of these are systemically dangerous. All should be closed. Today.

4. Yes, the lobbyists are a problem. What do you expect when you operate a revolving door between Wall Street and the administration? Goldman essentially runs the Treasury. The lobbyists are in Washington to meet with their former colleagues, and to oil that revolving door. There is only one solution: ban all former employees of the financial sector from government employment (including roles as advisors), and prohibit all government employees from ever working for a Wall Street firm.

5. It is not enough to subject banks to the requirements of the Volcker Rule. Any institution that has access to the Fed and to the FDIC should be prohibited from making ANY KINDS OF TRADES. They should make loans, and purchase securities, and then hold them. (An exception can be made for government debt.) They should perform underwriting and due diligence to ensure that the assets they hold meet appropriate standards of risk. And then they should bear all the risk through maturity of the assets. They should not be allowed to offload assets, much less to short assets that they sell, while knowing they are trash (Goldman’s favorite strategy). They should not be able to hedge risks through derivatives. They should not be allowed to purchase credit default “insurance” to protect themselves. They should not be allowed to move risk off balance sheet. They should not be involved in equities markets. Any behemoth that does not like these conditions can hand back its bank charter and become an unprotected financial institution. Those that retain their charters will be treated as public-private partnerships, which is what banks are. They put up $5 of their own money, then gamble with $95 of government (guaranteed) money. The only public purpose they serve is underwriting-and that only works if they hold all the risks.

6. Obama ignores fraud. It is rampant in the financial sector. Indeed, it has no doubt increased since the crisis. Where do you think all of those record profits come from? It is a massive control fraud, based on Ponzi (or Bernie Madoff) schemes. This must be investigated. Fraudulent institutions must be shut down. Management must be prosecuted and jailed. Only if Obama is willing to take on fraud will we know that he really is about hope and change. He has got to start with the Rubin, Geithner and Summers team. Fire them, then investigate them. That is change I can believe in-and an end to “business as usual”, as Obama put it. 

Earlier, Wray had included Federal Reserve chairman Ben Bernanke among the people who need to go. Bernanke is facing Senate confirmation of his nomination by Obama for a second term.  He faced ebbing support as more senators in both parties began adopting populist, anti-bank stance even as the White House launched a public push to defend his candidacy. Two Democratic senators facing re-election in November, Barbara Boxer of California and Russ Feingold of Wisconsin, on Friday joined two Democrats and an independent who previously announced their opposition. Ten Republicans say they, too, will oppose Mr. Bernanke, threatening the 60 votes, tow third majority needed to confirm him.
 
Still, Paul Volcker is hardly a White Knight to pull Obama out from this policy morass. Volcker will do for Obama in the 2012 election what he did to Carter in the 1980 election: deny him any prospect of a second term on the economic side.

I wrote in ATol on February 24, 2004 - The Presidential Election Cycle Theory and the Fed:
The late Arthur Burns, a conservative Austrian-born economist at Columbia University, was appointed Fed chairman by President Nixon in 1969 and served until 1978. The Burns era was the most opportunistically political in Fed history, with Burns’ ill-timed economic pump-priming designed merely to ensure Nixon a second term, by engineering money growth to a monthly average of 11 percent three months before the 1972 election, up from a monthly average of 3.2 percent in the last quarter of 1971. Nevertheless, Nixon’s second term was aborted by political complications arising from the Watergate scandal, leaving Gerald Ford in the wounded White House. The economy was left to pay for the Burns-created pre-election boom with runaway inflation that compelled the Fed to tighten with a post-election vengeance, which produced a long and painful post-election recession that in turn contributed to Ford’s defeat by Carter.

The Fed, as an independent institution above politics, has yet to recover fully from the rotten partisan smell of 1972. Burns’ sordid catering to Carter in hope of securing a reappointment for a third term was a contributing factor to the inflation under Carter. And Carter’s defeat by Ronald Reagan was in no small measure caused by the former’s appointment of Paul Volcker as Fed chairman. Some said it was the most politically self-destructive move made by Carter.

Volcker, having served four years as president of the New York Federal Reserve Bank, replaced G William Miller, an industry executive, as the Carter-appointed Federal Reserve Board chairman on July 23, 1979. As assistant secretary under Republican treasury secretary John Connally in the Nixon administration, Volcker played a key role in 1971 in the dismantling of the Bretton Woods international monetary system, formulated by 44 nations that met in Bretton Woods, New Hampshire, in July 1944 toward the end of World War II. Under that system - as worked out by John Maynard Keynes, representing Britain, and Harry Dexter White, an American who later in the McCarthy era was persecuted unfairly by accusation of having been a communist - each country agreed to set with the International Monetary Fund (IMF) a value for its currency and to maintain the exchange rate of its currency within a specified range. The United States, as the country with the leading economy, pegged its currency to gold, promising to redeem foreign-held dollars for gold on demand at an official price of $35 an ounce. (US citizens had been forbidden by law to own gold at any price since the New Deal was created under Franklin D Roosevelt.) All other currencies were tied to the dollar and its gold-redemption value. While the value of the dollar was tied strictly to gold at $35 an ounce, other currencies, tied to the dollar, were allowed to vary in a narrow band of 1 percent around their official rates, which were expected to change only gradually, if ever. Foreign-exchange control between borders was strictly enforced, the mainstream economics theory at the time being inclined to consider free international flow of funds neither necessary nor desirable for facilitating trade.

Nixon was forced to abandon the Bretton Woods fixed-exchange-rate system in 1971 because recurring lapses of fiscal discipline on the part of the United States since the end of World War II had made the dollar’s peg to gold unsustainable. By 1971, US gold stock had declined by US$10 billion, a 50 percent drop. At the same time, foreign banks held $80 billion, eight times the amount of gold remaining in US possession. Ironically, the problem was not so much US fiscal spending as the unrealistic peg of the dollar to $35 gold. Fixed gold-back currencies are simply not operational to expanding economies, and fixed exchange rates are not operational for economies that grow at different rates.
William G Miller, after only 17 months at the Fed, had been named treasury secretary as part of Carter’s desperate wholesale cabinet shakeup in response to popular discontent and declining presidential authority. After isolating himself for 10 days of introspective agonizing at Camp David, Carter emerged to make his speech of “crisis of the soul and confidence” to a restless nation. In response, the market dropped like a rock in free fall. Miller was a fallback choice for the Treasury, after numerous other potential appointees, including David Rockefeller, declined personal telephone offers by Carter to join a demoralized administration.

Carter felt that he needed someone like Volcker, an intelligent if not intellectual Republican, a term many liberal Democrats considered an oxymoron, who was highly respected on Wall Street, if not in academe, to be at the Fed to regenerate needed bipartisan support in his time of presidential leadership crisis. Bert Lance, Carter’s chief of staff, was reported to have told Carter that by appointing Volcker, the president was mortgaging his own re-election to a less-than-sympathetic Fed chairman.

Volcker won a Pyrrhic victory against inflation by letting financial blood run all over the country and most of the world. It was a toss-up whether the cure was worse than the disease. What was worse was that the temporary deregulation that had made limited sense under conditions of near hyper-inflation was kept permanent under conditions of restored normal inflation. Deregulation, particularly of interest-rate ceilings and credit market segregation and restrictions, put an end to market diversity by killing off small independent firms in the financial sector since they could not compete with the larger institutions without the protection of regulated financial markets. Small operations had to offer increasingly higher interest rates to attract funds while their localized lending could not compete with the big volume, narrow rate-spreads of the big institutions. Big banks could take advantage of their access to lower-cost funds to assume higher risk and therefore play in higher-interest-rate loan markets nationally and internationally, quite the opposite of what Keynes predicted, that the abundant supply of capital would lower interest rates to bring about the “euthanasia of the rentier”. Securitization of unbundled risk levels allowed high-yield, or junk, bonds with high rates to dominate the credit market, giving birth to new breeds of rentiers.

Ultimately, Keynes may still turn out to be prescient, as the finance sector, not unlike the transportation sectors such as railroads, trucking and airlines in earlier waves, or the communication sector such as telecom companies in recent years, has been plagued by predatory mergers of the big fish eating the smaller fish, after which the big fish, having grown accustomed to an unsustainably rich diet that damaged their financial livers, begin to die from self-generated starvation from a collapse of the food chain.

The Fed has traditionally never been keen on changing interest rates too abruptly, trying always to prevent inflation without stalling the economy excessively - thus resulting in interest rates often trailing rampant inflation - or stimulating the economy without triggering inflation down the road, thus resulting in interest rates trailing a stalling economy. Market demand for new loans, or the pace of new lending, obviously would not be moderated by raising the price of money, as long as the inflation/interest gap remains profitable. Deflation has a more direct effect in moderating loan demands, causing what is known as a liquidity trap or the Fed pushing on a credit string.

Yet bank deregulation has diluted the Fed’s control of the supply of credit, leaving the price of short-term money as the only lever. Price is not always an effective lever against runaway demand, as Fed chairman Alan Greenspan was also to find out in the 1990s. Raising the price of money to fight inflation is by definition self-neutralizing because high interest cost is itself inflationary in a debt-driven economy. Lowering the price of money to fight deflation is also futile because low interest cost is deflationary for creditors who would be hit by both loss of asset price, deteriorating collateral value and falling interest income. Abnormal gaps between short- and long-term interest rates do violence to the health of many financial sectors that depend on long-term financing, such as insurance, energy and communication. Deregulation also allows the price of money to allocate credit within the economy, often directing credit to where the economy needs it least, namely the high-risk speculative arena, or desperate borrowers who need money at any price.

The Fed might have had in its employ a staff of very sophisticated economists who understood the complex, multi-dimensional forces of the market, but the tools available to the Fed for dealing with market instability was by ideology and design simplistic and single-dimensional. Interest-rate policy has been the only weapon available to the Fed to tame an aggressively unruly market that has increasingly viewed the Fed as a paper tiger.
 
The Rasmussen Reports daily Presidential Tracking Poll for Friday, January 22, 2010, shows that only 25% of the nation's voters ‘Strongly Approve’ of the way that Barack Obama is performing his role as President, while 43% ‘Strongly Disapprove’, giving Obama a Presidential Approval Index rating deficit of minus 18.  Overall, 45% of voters say they at least somewhat approve of the President's performance, while 54% disapprove. A year earlier, at the beginning of his presidency, Obama scored on January 20, 2009 a 43% ‘Strongly Approve’ rating with a 13% ‘Strongly Disapprove’ rating, a Presidential Approval Index rating surplus of plus 30. Overall approval rating fell from 65% when he took office on January 21, 2009 to 45% a year later on January 22, 2010. This reflects heavy loss of voter support due primarily to his failure to revive the economy, particular to reverse the job loss and unemployment trends. Related to his failure to revive the economy is the loss of jobs. There is much popular disappointment in Obama’s failure to maintain leadership momentum in his healthcare reform plan to allow a divided Congress to butcher results.
 
Evidence of Obama’s non-existent political coattail was the inability of his last minute visit to Massachusetts to help save the failing Democrat campaign for the Senate seat of the late Edward Kennedy.  
 
Congressman Frank Recommends Replacing Fannie Mae, Freddie Mac
 
Representative Barney Frank (D – Massachusetts) chairman of House Financial Services Committee that oversees Fannie Mae and Freddie Mac, the government sponsored enterprises (GSE), said he will push to do away with the companies in favor of a new, improved model for US mortgage financing.
 
The GSEs, the largest sources of money for U.S. home loans, were seized by regulators in the summer of 2007 because of their high risk of failing with house mortgage delinquency reach over 25% have since survived on $110.6 billion in taxpayer-funded aid to keep the GSEs solvent in their mortgage-backed securities. Frank said Congress also needs to figure out what to do with the remaining heavily battered shareholders in Fannie Mae and Freddie Mac as well as investors in the GSEs’ $5.4 trillion in mortgage bonds and $1.7 trillion in unsecured corporate debt.
 
The Treasury Department took an 80% equity stake in each company as part of the government’s September 2008 takeover, which wiped out the majority of common and preferred share values. Fannie Mae common shares, which peaked at $87.81 in December 2000, fell to less than $1 today. Freddie Mac shares, which reached an all- time high of $73.70 in December 2004, are trading now around $1.17.
 
Fannie Mae is a New Deal housing finance agency dating back to the 1930s. Freddie Mac was started in 1970. They were chartered by the government with the mandate to lower the financial cost of homeownership.  They buy mortgages from lenders, freeing up cash at banks to make more loans. GSEs are the biggest mortgage-backed securitization entities, making profit by the interest rate spread.
 
The companies now own or guarantee more than $5 trillion in U.S. residential debt, and were responsible for as much as 75 percent of the new mortgages made in 2008.
 
Fannie Mae and Freddie Mac have been run for more than 40 years as shareholder-owned companies that also have a federally chartered mission to promote the housing market. Those dual mandates have collided and contributed to the companies’ failure.
 
Fannie Mae has posted $120.5 billion in net losses in the nine quarters ended in September 2009 and requested $59.9 billion in Treasury aid to remain solvent. Freddie Mac has lost $67.9 billion and sought $50.7 billion in taxpayer-funded aid.
It’s a business culture where the rich and well-connected get richer while the employees, shareholders and customers get the shaft. And the conviction that the game is fixed is nonpartisan. If the tea party right and populist left agree on anything, it’s that big bailed-out banks have and will get away with murder while we pay the bill on credit cards — with ever-rising fees.
 
The economic decline dominated the political climate. No other issue counts. In the January 22, 2010 Washington Post/ABC News pool, 42% of Americans chose the economy as the country’s most pressing concern. Only 5% picked terrorism, and 2% Afghanistan. By default, Obama’s highest approval ratings are now on foreign policy and national security issues.  Obama stumbled not because his moved too far to the left, but because he positioned himself in political Neverland, squandering his political capital by being too abstract, too measured and too obsequious to a contentious Congress only loosely controlled by his own divided party, with the Blue Dog democrats frequently voting with the Republicans against the liberals
 
Health care, despite all the press coverage, was chosen only by 24% of the population as a pressing concern. Obama, the eloquent speechmaker, failed to clearly communicate the bottom line of his health reform bill to voters, allowing opposition to make outrageous attacks that cannot be definitive challenged. The eloquent speech maker failed to deliver a coherent message on Health care reform, his centerpiece policy. He failed to explain clearly why health care reform needs to be tackled before economic recovery. Most families still do not know clearly what the health care plan means for them financially, how it will impact their tax liabilities, or insurance burden. This fuzziness was accentuated by tiresome bickering between the Senate and the House, allowing reform to be caricatured by its foes without appearing deceptive. In themean time, time is running out as the mid-term election approaches.
 
On the economic front, Obama desparately needs a new team. The centrists that followed Obama into the White House are all Goldman Sachs-Rubin alumni who have played major parts in allowing the crisis to fester unregulated.  They are so tainted by its back-room health care deals with pharmaceutical and insurance companies that conservative politicians, Scott Brown of Massachusetts included, can masquerade creditably as the populist alternative to Wall Street populists.
 
The proposal to subject some bank liabilities to a financial crisis responsibility (FCR) fee highlights the unintended consequences of regulating an industry that depends on an obscure but crucial funding mechanism. The $3.8 trillion repo market, in which top rated securities are used as collateral for short-term loans, is unsettled by the proposed FCR fee.
A fee of 15 basis points would be paid on all liabilities not already subject to an insurance premium paid to the Federal Deposit Insurance Corporation.
 
That places the repo market – which is used by banks for funding a large amount of their liabilities – in the direct line of fire. It also has implications for bank funding via commercial paper and could affect trading in the overnight rate set by the Federal Reserve.
 
A 15 basis point tax on bank assets above $50 billion will have a devastating effect on the repo market because typical repo operations at Wall Street dealers do not generate a spread of 15 basis points. As a result, this tax strongly motivates primary dealers of US securities to reduce financing provided to clients for government securities transactions.
While banks use repo to borrow cash for short periods, which helps fund their balance sheets, they also provide funding for investors wanting to buy the securities. The difference banks earn between the interest rate they borrow at and the one they lend at is reflected by the narrow 5 basis points bid/offer spread in repo, which would be swamped by a 15 basis points charge. The dealer to customer market in repo will lose liquidity, particularly at times when the tax is expected to be calculated – at the end of a quarter or year. If higher costs for those borrowing through the repo market force investors to seek alternatives such as derivatives, returns for lenders, such as money market mutual funds, could become lower. Such entities, which hold more than $3,200bn in assets, are large lenders through repo. The industry, which predominantly holds short-term, liquid investments, is already struggling because low interest rates have pushed yields on funds close to zero.  Disrupting the repo market could also affect mooted plans by the Federal Reserve to use large-scale reverse repos to drain excess banking reserves from the monetary system – part of its “exit strategy” to unwind extraordinary policies put in place after the financial crisis.
 
Also, the Fed funds market, the overnight rate set by the central bank, would be affected by the FCR. Once the Fed has reduced some of the excess reserves in the system, the implementation of monetary policy will rely in part on banks buying funds in the market and leaving the cash on deposit at the Fed, whenever the funds rate drops below the target level set by the Fed. Under the FCR the risk is that large banks will not do that until Fed funds trade 15bp below the rate on excess reserves. As the industry and repo market digest the implications of such a fee, many expect a pushback against the current version.
 
It appears that a week of populist revolt against Obama’s economic team has ended with signs that Mr. Obama would retain, at least for now, his two highest-profile economic policy allies: Tim Geithner and Ben Bernanke.
“Tim Geithner helped steer the financial sector and the entire economy through the worst crisis since the Great Depression,” Mr. Emanuel said in an interview. “He’s not going anywhere.”
 
In a perverse sort of way, Emanuel is spot on: Bernanke’s monetary policy at the Fed and Geithner’s fiscal policies at the Treasury do appear to be not going anywhere fast.
 
Yet Obama Can Be the First President in History to Abolish Unemployment From the Economy

The first year of the Obama presidency has been a monumental disappointment. By now, the President’s populist rhetoric of "change we can believe in" rings hollow against the hard data of the sad shape of the economy.

The critical bottleneck to recovery is the continuing loss of jobs.  Conventional economic wisdom asserts that employment is the lagging indicator. Unemployment cannot be expected to fall until after the economy recovers.  But in an economy that suffers from overcapacity due to low wages, as the world economy is today, economic recovery from excessive debt cannot be achieved without full employment with living wages to produce the needed rise in demand to absorb overcapacity. The government, despite its enormous power to intervene in the economy on the supply side, is stuck in a self-perpetuating vicious cycle of stagnation caused by unemployment that in turn causes stagnation.
 
In contrast, the Chinese Ministry of Human Resources and Social Security just announced that China created 11.02 million new jobs in urban areas in 2009, topping the government goal of 9 million.  Still, China’s unemployment problem is a long way from being solved. Around 5.14 million laid-off workers were re-employed last year, exceeding the preset goal of 5 million. Urban unemployment rate stood at 4.3 percent, with 9.21 million people being registered as unemployed.

Yet all is not lost for Obama. The President needs only to reestablish his political leadership with bold and effective action to deliver help directly to deserving workers rather than to failed undeserving financial firms that are allegedly too big to fail.  One way to do this is for President Obama to use the coming State of the Union address at the beginning of the second year of his presidency to announce that he will be the first president in US history to abolish unemployment in the US economy.  He will be the president who will smash the destructive myth that structural unemployment is needed to hold down inflation even in a deflationary cycle.

This is not an impossible task. The US now has 6.5 million unemployed workers, 4 million of whom joined the unemployment rank during the first year of the Obama presidency.  The President can introduce a Full Employment Program starting February 1, 2010 to give a job to every American who wants one, to be funded by a Full Employment Fund constructed out off already appropriated but yet unspent bailout and stimulus money. These jobs can be socially constructive jobs such as teachers, nurses, caretakers of children and seniors, police, artists, health workers, writers, inventors, research scientists etc., with the prime function of increasing demand in the economy.
 
At the rate of the 2008 national average wage of $42,000, a program to fund 6.5 million jobs will cost $270 billion a year. In the past two years, the government has committed over $20 trillion in various form of bailout and stimulus packages, with very little to show for it in the form of economic recovery.  The not yet spent portion of this $20 trillion can fund full employment for more than three years at a declining rate. As this money is injected into the economy in the form of living wages, the resultant rise in demand will increase the utilization of the capital assets to reduce overcapacity. A balance between supply and demand will be maintained by full employment to permit the economy to grow again.

The resultant growth in the economy will reduce the spending rate of the Full Employment Program way before the allotted money is depleted.  With full employment, the US economy of $14 trillion GDP can grow at a 6% annual rate, producing an additional GDP of $560 billion the first year. The $270 billion Full Employment Fund will be repaid in less than 4 years to erase unemployment from the economy.
 
That would be a change we can believe in.

January 22, 2010