The U.S. Department of Justice: Big Banks May Legitimately Be above the Law

The Financial Times reported in 2013 that lawmakers in the U.S. Congress were claiming that the Department of Justice had been “too soft on big banks and their executives by failing to bring criminal cases related to the financial crisis.”[1] In the five years following the financial crisis of 2008, no Wall Street executive was criminally charged with fraud. The U.S. Justice Department chose not to go after the bankers for their lack of due diligence regarding their purchases of sub-prime mortgages from mortgage originators. This in spite of the fact that at Citibank, for example, a manager in the bank’s due diligence department estimated that 50% to 80% of the approved mortgages did not meet the bank’s credit policy, and yet Robert Rubin, the CEO at the time, did not act on the manager’s email. This suggests that a criminal complaint could have been lodged against the bank itself, but then what would be the implications for the financial system should Citibank had gone under after being found criminally guilty? Does it even hold that a guilty verdict would mean bankruptcy? Simply stated, a company can be so large that its failure due to a guilty verdict could harm innocent third parties, including stockholders, employees, suppliers, and even the general public if the bankruptcy triggers a systemic collapse of the financial system. Such concerns are called collateral consequences. After the collapse of Lehman Brothers in September 2008, systemic risk became a particularly salient concern for criminal prosecutors at the U.S. Department of Justice. Swayed by a desire to minimize the potential disproportionate harm to innocent parties from a verdict-triggered major bankruptcy, the prosecutors believed they were obligated to consider collateral consequences even if that meant that the really big banks would be immune from criminal prosecution. To such banks, this could be used as a competitive advantage because keeping within the constraints of law in making money would not apply. I contend, therefore, that the U.S. Government should not have taken collateral consequences into consideration. 

The full essay is "Big Banks above the Law."

 Mythili Raman testifying before Congress. mainjustice.com

1. Shahien Nasiripour and Kara Schannell, “Holder Says Some Banks Are ‘Too Large’,” The Financial Times, March 7, 2013.

Decreasing Bank Size by Increasing Capital-Reserve Requirements: Plutocracy in Action?

Although the Dodd-Frank Financial Reform Act was passed in 2010 with some reforms, such as liquidity standards, stress tests, a consumer-protection bureau, and resolution plans, the emphasis on additional capital requirements (i.e., the SIFI surcharges) could be considered as weak because they may not be sufficient should another financial crisis trigger a shutdown in the commercial paperr market (i.e., banks lending to each other). A study by the Federal Reserve Bank of Boston found that even the additional capital requirements in Dodd-Frank would not have been enough for eight of the 26 banks with the largest capital loss during the financial crisis of 2008. As overvalued assets, such as subprime mortgage-backed derivatives, plummet in value, banks can burn through their capital reserves very quickly. A frenzy of short-sellers can quicken the downward cycle even more. This raises the question of whether additional capital resources would quickly be "burnt through" rather than being able to stand for long as a bulwark. The financial crisis showed the cascading effect that can quickly run through a banking sector as fear even between banks widens as one damaged bank impacts another, and another. 

The full essay is at "Manipulating Bank Size by Reserves."

Addressing Systemic Risk: Beyond the Dodd-Frank Act of 2010

After the financial crisis in September 2008 in the U.S., the former chairman of the Federal Reserve, Alan Greenspan, admitted to a Congressional committee that his free-market notion that a market will automatically self-correct itself had a major flaw. He had come to this realization because the financial market for mortgage-backed bonds had failed to correct in terms of price for the dramatic increase in risk. Instead, that market, and that of overnight commercial paper, had seized up rather than simply adjust price to the decreased demand. Fear had paralyzed what had hitherto been thought to be a self-correcting market. The failures of Bear Stearns and Lehman Brothers introduced us to the concept of systemic risk, wherein the failure of a bank (or company) causes a market to collapse. Such a bank is thus too big to fail. If actualized, such risk interferes with even the basic operation of a market, not to mention its self-correcting feature. One question is whether banks that are too big to fail should merely be more adequately regulated or broken up, as the U.S. Supreme Court broke up Standard Oil in 1911.

Alan Greenspan, former chairman of the U.S. Federal Reserve Bank

   The full essay is at "Addressing Systemic Risk: Alan Greenspan."

The Market Mechanism: Complicit in E.U. Debt Crisis

According to The New York Times in late 2011, “How European sovereign debt became the new subprime is a story with many culprits, including governments that borrowed beyond their means, regulators who permitted banks to treat the bonds as risk-free and investors who for too long did not make much of a distinction between the bonds of troubled economies like Greece and Italy and those issued by the rock-solid Germany.” In going through these culprits and how they interrelated, it should not be lost that the market mechanism itself can be held as suspect, for at the very least it enabled the furtive games to be played for far too long. Indeed, the market itself did not do a good job for years in providing accurate risk-return relationships.

The full essay is in, "Essays on the E.U. Political Economy," available at Amazon. 

Unnecessary Systemic Risk: Banks' Price-Fixing and Racketeering in Side Businesses

A lawsuit filed in a Florida district-court in 2013 alleged that JPMorgan, Goldman Sachs, and the London Metal Exchange (LME) artificially inflated aluminum prices.  The plaintiffs accused the companies of anti-trust practices and racketeering, including the “manipulation of the aluminum market through supply price fixing.”[1] This sounds like what had led to the forced break-up of Rockefeller’s Standard Oil Company, though in that case exactly a century before, the restraint of trade had to do with the company’s main line of business (i.e., oil). In the case of the banks, however, owning commodity assets such as storage facilities and trading in raw materials do not constitute banking. This point triggers a larger question involving the repeal of the Glass-Steagal Act.

Should we allow banks to expand even beyond these functions to owning commodities and related real-estate? What does this do to the banks' systemic risk?    Image Source: salisburyareafoundation.org. 

The full essay is at "Unnecessary Systemic Risk in Banking."

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[1] Melanie Burton, “Glencore, JPMorgan Sued Over Warehouse Aluminium Prices,” Reuters, August 7, 2013.

Paul Volcker on the Market and Regulation

Paul Volcker, former Chairman of the Federal Reserve, may strike the conventional "wisdom" as an oxymoron regarding the market mechanism and government regulation. I contend that he could have taught that "wisdom" a lesson or two.

The full essay is at "Paul Volcker on the Market and Regulation."

Is Modern Banking Fundamentally Flawed?

Jamie Dimon, CEO of JP Morgan Chase and board member of the New York Federal Reserve (a banking regulatory body), advocates not only that financial regulation reform is not necessary, but also that deregulation is the best course for the American financial sector. Meanwhile, JP Morgan lost $2 billion in an effort to reduce risk. President Obama quickly pointed out that if one of the smartest bankers in the room can preside over such a massive loss, then a deregulated financial sector would likely present us with an unacceptably high level of risk to the entire financial system (and economy). Elizabeth Warren suggested that relying on bankers to regulate themselves would not reduce the systemic risk. The alternative would seem to be strengthening financial regulation, even though—according to Sen. Dick Durbin—“the banks own Congress.”

The full essay is at " Banking as Flawed."

Market or Government: Which Should Reduce Systemic Risk in the Banking Industry?

If the five largest banks—JP Morgan, Bank of America, Citigroup, Goldman Sachs, and Morgan Stanley—are too big to fail and yet substandard operationally on account of their respective complexities (e.g., investment banking added to commercial banking), might it be that the market-based decisions of investors will relegate the giants, which by the way had price-to-book value ratios of between .37 to .77 in May 2012, thereby solving the problem of systemic risk?

The full essay is at "Reducing Systemic Risk: The Market or Government?"

Obama Standing Up to Wall St.: Fact or Fiction?

From the time of the Obama Administration, a major newspaper concluded: “What haunts the Obama administration is what still haunts the country: the stunning lack of accountability for the greed and misdeeds that brought America to its gravest financial crisis since the Great Depression. There has been no legal, moral, or financial reckoning for the most powerful wrongdoers. Nor have there been meaningful reforms that might prevent a repeat catastrophe. Time may heal most wounds, but not these.”

For analysis, see "Obama Standing Up to Wall Street: Fact or Fiction?"

Too Big to Fail: The Trillion Dollar Club

Banks with assets over $50 billion are considered “systemically important” according to the Dodd-Frank law of 2010. The act is geared to shoring up protection against systemic risk. The U.S. Government deems certain banks (and companies) systemically important if they are big enough to threaten the entire financial system should they fail. Such enterprises are subject to higher capital standards and stricter rules. Roughly three dozen banks in the U.S. had been classified as systemically important by mid-May 2011.

The full essay is at "Too Big to Fail."

Financial Reform: Did Congress Shoot a Blank?

On the third anniversary of the Dodd-Frank Act, former U.S. Senator Ted Kaufman (D-DE) penned an excellent yet concise critique of the law’s efficacy over three years. The news is not good. I submit that it is worse than Kaufman is willing to admit—worse in the sense that Congress had mishandled the writing of the bill before it became law. I will get to this matter after summarizing Kaufman’s points.

                                                                                                     Former Sen. Ted Kaufman

  
Kaufman points out that the big banks can still take high-risk gambles with FDIC-insured deposits. Essentially, the U.S. taxpayer is underwriting the additional risk. The mammoth $6.2 billion “London Whale” loss at JP Morgan in 2012 suggests that the banks are indeed taking advantage of the loophole. Kaufman points to a second loophole. Although Dodd-Frank contains new regulations on the financial derivatives that had played such a dramatic role in the near-meltdown in September 2008, the big banks can simply move their financial derivatives to “off shore” offices. Citigroup alone has more than 2,000 foreign subsidiaries.[1]

As for the dysfunctional Fannie Mae and Freddy Mac, Kaufman points out that they are not even mentioned in Dodd-Frank! Nor can any solution to the structural conflict of interest facing the rating agencies, which are still “bought and paid for by the entities they rate.”[2] Nor, I might point out, does the law do anything to obviate the “client-pays” conflict of interest facing public accounting firms (e.g., Arthur Andersen as the “permissive” auditor of Enron). I would generalize to suggest that American lawmakers and the general public are woefully ignorant of the harm just in looking the other way rather than deconstructing an institutional conflict of interest. In fact, I submit that such a conflict is inherently unethical, rather than being so only if it is exploited.

As for the “ordered liquidation” feature of Dodd-Frank, Kaufman’s critique portrays the mechanism as if it were a sand castle sitting just above a rising tide. Although making actual sand castles on some beach might teach members of Congress how to get along, an orderly liquidation of one bank is not likely to be sufficient to stop the contagion of fear and short-selling from spreading to other banks, as they are so interconnected. Would an orderly liquidation procedure invoked for all of the large banks stave off the collapse of the financial system? 

Kaufman cites an analysis by Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp., which finds that JPMorgan Chase, Citibank, and Bank of America had become the three largest banks globally during the three years of Dodd-Frank’s existence. Add in Wells Fargo and those four banks have combined assets of 97% of the U.S. GDP in 2012.[3] Given the continued high-risk trades and possibility of off-shore financial derivative “bundling” and selling, the “too big to fail” problem has grown more perilous, not less. Meanwhile, only 155 of the 389 rule makings required by Dodd-Frank were finalized during the law’s three years of existence.[4] Put another way, a law that is utterly insufficient to eliminate the “too big to fail” systemic risk was after three years still “half baked.” The obvious question is why, and in Washington that question is answered in terms of power.

Kaufman points to the legislators in Congress who “passed the buck” to the regulators, who would have to face the powerful Wall Street lobbyists. However, he doesn’t include the impact of those lobbyists on the members of Congress themselves. That is to say, the law may have been watered down as it was being written, or “marked up,” as lawmakers gave too much influence to the financial interests that would face stiffer regulation. It is not uncommon for legislative aides to use legislative clauses written by the regulated entities themselves. Here we have stumbled on yet another tolerated structural conflict of interest!

Therefore, we can generalize perhaps in concluding that the Dodd-Frank law is insufficient even in theory, let alone practice, to solve the problem of systemic risk because of the excessive influence of Wall Street over lawmakers. As Sen. Dick Durbin said in the wake of the banks' culpability in 2008, the banks still "own" Congress.[5] That is, the endurance of excessive systemic risk has in great part been due to Congress having become more of a plutocracy than a house of the people. Consider, for example, how much chance the proposal by Sens. Warren and McCain to break up the megabanks has in the U.S. Senate (not to mention the House!), and it will be clear just how much power Wall Street actually has in Washington. This is the real problem, any solution to which is sadly not even on the horizon, and this is, kein Zufall, no accident either.

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1. In a “slip of the tongue,” Kaufman wrote “subsidies” instead of “subsidiaries.” Might he have been wanting, at least unconsciously, to tell us more?

2. Ted Kaufman, “Happy Birthday to Dodd-Frank, A Law that Isn’t Working,” Tedkaufman.com. Accessed July 22, 2013.

3. Ibid.

4. Ibid. Kaufman cites the Davis Polk law firm as coming up with the numbers.

5. U.S. Sen. Dick Durbin (D-IL) said “Congress is owned by the banks” after they stopped his amendment that would have allowed judges to modify contested mortgages in foreclosure.

Banks in Trouble: European Populism?

In reaching agreement on a proposal to deal with state banks in trouble, the E.U. finance ministers sent two messages: taxpayers would be protected from any open-ended obligation to bail out failed banks and those banks would not be allowed to capitalize on being bailed out. Given the furor that had been unleashed when the E.U. went after depositors in the two largest Cypriot banks, the E.U. ministers were careful to point out “that depositors with less than €100,000 ($130,820) in their accounts would always be safe, while small and midsize companies and bigger savers would only be hit during the most severe bank failures.” Systemically important banks whose failure could be expected to cause the E.U. financial system to collapse would be handled on a case by case basis.

Will the euro be fortified by a federal bank-bailout program?   Source: Estonia Free Press.

The full essay is at "Essays on the E.U. Political Economy," available at Amazon.

A "Banking Union" or Coordinated State Laws and Regulations?

A subtle though important difference exists between American and European federalism, each of which covers both the "kingdom" (i.e., early modern, now mostly republics) and "empire" (i.e., ancient and early modern, now usually huge federal systems) scales. So I am referring to federal systems like the U.S., E.U. and Russia (and U.S.S.R), rather than to federal systems within any of their respective political subunits (e.g., Belgium, the Netherlands, and Germany). The difference between the E.U. and U.S. that I discuss here can be grasped by looking at the two competing proposals for federal bank regulation in the European Union. The crucial question facing the E.U. finance ministers concerns which system of government. 

The complete essay is at Essays on Two Federal Empires.

This picture depicts the distinctive European model of modern federalism wherein the state governments play a salient role in implementing (and modifying) federal law.   source: mapperywordpress.com

E.U. Passes Financial Transactions Tax (FTT)

Out of a “desire to ensure that the financial sector fairly and substantially contributes to the costs of the crisis and that [the sector] is taxed in a fair way [relative to] other sectors for the future, to disincentivise excessively risky activities by financial institutions, [and] to complement regulatory measures aimed at avoiding future crises and to generate additional revenue for general budgets or specific policy purposes,” the Council of the European Union took a decision on 14 January 2013 to allow 11 states, including Belgium, France, Germany, and Italy, to act in a coordinated fashion with the Commission and each other in establishing and administrating a tax on financial transactions. That is to say, the tax is to be jointly administered by the Commission and the states, and both levels would share in the proceeds. A few states, most notably Britain and the Czech Republic, abstained in the voting.

The full essay is at Essays on the E.U. Political Economy, available at Amazon. 

Fixing the Foreclosing Banks: A Hidden Conflict of Interest in Regulatory Compliance

After the financial crisis of 2008, regulators in the U.S. ordered banks to hire consultants to implement more than 130 “enforcement actions,” which represent 15% of the cases. In 2011 alone, regulators mandated that eleven banks hire consultants to determine whether mortgage borrowers had been wrongfully evicted. The consultants collected about $2 billion in fees, which amount to more than half of what homeowners were to receive under the $8.5 billion settlement that ended the consultants’ work. According to regulators, the consultants’ work was plagued with inefficiencies. This is probably the least of it, for virtually any expectations for “an industry that is paid billions of dollars by the same banks it is expected to police” are bound to be chimerical in nature.

The full essay is at Institutional Conflicts of Interest, available at Amazon.

Eminent Domain and Sanctity of Contract: Mortgage-Relief as “Dangerous”

With about half of the mortgages “under water” (i.e., being more than the houses are worth in terms of market value), government officials in San Bernardino County floated a proposal in 2012 to use California’s sovereign power of eminent domain to buy up the mortgages, cut them to the current value of the homes, and resell the mortgages to a private investment firm, which would allow the homeowners to lower their monthly payments and stay in their homes. The New York Times labels this a “drastic option,” coming from a government that was “(d)esperate for a way out of a housing collapse that has crippled the region.” This characterization of the proposal as “radical” fits with the bankers’ financial interest and perspective. In actuality, eminent domain is typically understood to be a basic power of government.

Doubtless the amounts that the government would pay as it exercises its right of eminent domain would not be satisfactory to the bankers holding the mortgages, for the “mere idea . . . rankled” the bankers, whose leaders claimed that it would set “a dangerous precedent of allowing a government entity to act as a lender and would discourage banks from loans in the area.” The danger may be in the eye of the beholder, particularly if he or she is accustomed to exacting the sanctity of contract as if not even a government could touch it. In other words, the exaggerated response may reflect the mistaken belief that eminent domain is somehow illegitimate for a government. This belief is reflected in the expectation of Ken Bentsen, an official of the Securities Industry and Financial Markets Association, that the proposal would almost certainly be challenged in court.

“If the government has the ability to abrogate the contract at will and at the expense of the bond holder, the investor is going to do one of two things: require a tremendous premium for the risk they are incurring, or just not invest at all,” Ken Bentsen said. “It would be a risk factor that would be impossible to underwrite.” Government does have the right to abrogate or nullify a contract “at will.” It is not as though government were merely a business; governmental sovereignty does not apply to the private sector, yet this does not detract from government’s distinctive role in society. Furthermore, the claim that lending would dry up without a huge risk premium assumes that other governments would not follow suit and that the banks would otherwise be able to enforce the sanctity of the contracts against borrowers under water.

In fact, the bankers’ insistence to have it all their way may have set them up to get far less. Greg Devereaux, San Bernardino County’s chief executive, expressed frustration with the level of the bankers’ opposition to the plan. “If they want to come and talk and propose other solutions, great, but that’s not what is happening. Instead they are just trying to kill it because they have nothing but their own interest in mind.” He has hit on the crux of the problem. Having nothing but their own financial interest in mind, the bankers had opposed even an amendment submitted by Dick Durbin of Illinois that would have permitted bankruptcy judges to modify mortgages.

Under the mistaken belief that sanctity of contract transcends even governmental sovereignty as if under natural law (but not that which prohibits usury!), the bankers applied “drastic” and “dangerous” to the “usurpation at will” by eminent domain, as if it were suspect or at the very least sordid in nature. In actuality, it is the bankers’ insistence on having it all their way that is squalid and ultimately self-defeating. The government’s invoking of eminent domain can be viewed as a reaction to the bankers’ self-defeating rigidity or stubborn selfishness.

Preferring foreclosure to adjusting mortgages that are under water (i.e., remaining book value over the market value of the property), the bankers were sitting ducks for any government official aware of the nature of governmental sovereignty as not being constrained by sanctity of contract. While excessive use of such sovereignty would doubtless detract from parties otherwise willing to enter into a contract, San Bernardino’s plan was hardly over-encompassing or capricious. Indeed, the limitation that the mortgage borrower must be current on payments is a self-defeating and unnecessary limitation imposed by the government on its own plan. Borrowers most in need should not be eliminated at the outset; rather, they should be encouraged to take part, and this would not cause future lending to somehow collapse without customers having to be gauged by banks under the pretense of a “risk premium.”

In short, government’s use of eminent domain is fitting and proper in protecting bank customers from unreasonable bankers in line with the public interest that people not be thrown out of their houses. It is not as if a government were somehow a peer or even a rival of a bank. Rather, government is tasked with providing a floor such that no one faction in society extracts too much from another segment, even if in line with a contract. Government can so act “at will.” The permission of banks is not required, or frankly even helpful, in the workings of governmental sovereignty.

The bankers seem to have been presuming that they themselves, as guardians of the sanctity of contract, are sovereign or at least just as sovereign as governments are. If so, the danger lies in permitting those self-interested associations a role in their capacities as entities distinct from their members in lobbying government officials or regulators even and especially on matters touching on the entities’ respective financial interests. The danger includes distortion and hyperbole rather than greater insight for policy-makers.

It would be sad indeed were the plan of the government of San Bernardino county (i.e., the sovereignty of that government, which is ultimately that of the Republic of California) finally dependent on the financial/political power of the investment company participating as a “middle man” in the plan, specifically in countering the financial/lobbying power of the banks. That is to say, the sovereignty of governments being used in the public good should not have to depend on a particular result of the “invisible hand” of private self-interests as if sovereignty were a market-based outcome of lobbying.

Source:

Jennifer Medina, “California County Weighs Drastic Plan to Aid Homeowners,” The New York Times, July 14, 2012. http://www.nytimes.com/2012/07/15/us/a-county-considers-rescue-of-underwater-homes.html?pagewanted=1&ref=business

See: Cases of Unethical Business: A Malignant Mentality of Mendacity, available in print and as an ebook at Amazon.

Barclays: Riddled with Conflicts of Interest

Lest it be presumed that no harm to society can come from having Wall Street bank CEOs such as Jamie Dimon (of JP Morgan) on the New York Fed’s board of directors, Marcus Agius, the former chair of Barclays who resigned after his bank agreed to pay $450 million to settle accusations of rate-setting, was also the honorary chairman of the Bankers’ Association of the state of Britain in the E.U. That association oversees one of the key rates in question, the London interbank offered rate, or Libor.

The full essay is at Institutional Conflicts of Interest, available in print and as an ebook at Amazon.

JP Morgan Chase on the NY Fed's Board

The New York Fed allows private bankers to sit on its board, even while it crafts bank policy and puts together financial industry bailouts. "There's a conflict of interest here. You serve two masters. You can't draw this extraordinary salary from JPMorgan Chase and, at the same time, say, 'Oh, I'm out here acting in the public interest.' You can't do both." So said Elizabeth Warren, who came up with the idea that became the Consumer Financial Protection Bureau as part of the Dodd-Frank Financial Reform Act of 2010. Referring to Jamie Dimon, the CEO of JP Morgan who presided over a $2 billion trading loss, she added, "He says he wants to take responsibility. Then show some responsibility. Show you get it. Putting Wall Street bankers on the Federal Reserve Board is like finding the guys who torched the entire town and putting them on the fire advisory board. It makes no sense." 

The full essay is at "JPMorgan: An Unethical Monstrosity?"

Banks Coopting the Consumer Protection Agency

According to the Credit Card Act, which took effect in February 2010, credit-card issuers cannot charge fees equal to more than 25% of the borrower’s credit limit in the first year after the account is opened. A question confronting the Consumer Financial Protection Bureau was whether up-front fees charged before the account is open count toward the limit. The new agency decided against subjecting such fees to the limit. The question is why.

The full essay is at "Banks Coopting the Consumer Protection Agency."

Conflicts of Interest at the Federal Reserve

In 2011, “(m)ore than a dozen members of the regional Federal Reserve boards have had ties to banks or companies that received emergency funds during the [2008 financial] crisis, according to [a GAO report]. The report highlights a close relationship between the Fed's regional banks and many of the institutions they were lending to, adding credence to concerns that the financial sector enjoyed a largely consequence-free rescue in the wake of the crisis, thanks to its connections with the federal government.”[1] Meanwhile, mortgage borrowers with houses “under water” got hammered. From the crisis to the release of the GAO report in October 2011, there were millions foreclosures in the United States, with very little in the way of mortgage modifications or refinancing for those homeowners who needed relief. In other words, the bankers had connections in the banking regulatory agency while Congress left the troubled homeowners—constituents—at the mercy of the bankers. Their agency having their backs, the bankers could afford to take a hard line on the mortgages. The playing field, in other words, is not at all level. 


Material from this essay has been incorporated into "The Federal Reserve" in  Institutional Conflicts of Interest, which is available in print and as an ebook at Amazon.  

1. Alexander Eichler, “Conflicts of Interest Abound at the Federal Reserve, Report Finds,” The Huffington Post, October 19, 2011.