GLASS-STEAGALL 101

We are entering the section on economic policy making in my Introduction to American Politics class. Last week we made it to the Great Depression and discussed the rationale behind the Glass-Steagall Act. For those of you who are not familiar with the Glass-Steagall Act (1933) you can read about it in my book, or you can get a broader history from PBS here.

In brief, the Glass-Steagall Act (also known as the Banking Act of 1933) was passed by Congress in 1933. It specifically prohibited local commercial banks from doing what Wall Street investment banks do. It was enacted in response to the failure of nearly 5,000 local banks who, you guessed it, were using the bank deposits of their customers to gamble on investments and other projects they knew little about.

While Glass-Steagall was made possible by the stellar investigations done by the Pecora Commission, Franklin D. Roosevelt made it a cornerstone of his New Deal program.

Ferdinand Pecora

The Glass-Steagall Act gave the federal government more control over national banks, created the Federal Deposit Insurance Corporation (FDIC), and prohibited bank sales of securities. It didn't keep Wall Street from gambling with money from their clients accounts (see here and here) but it did protect the little guy on Main Street, for over 50 years.

Here's MSNBC's Dylan Ratigan explaining how Glass Steagall actually worked:

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After being attacked by Wall Street for years Glass-Steagall was finally repealed in 1999 when President Bill Clinton signed the Financial Services Modernization Act (aka Gramm-Leach-Bliley). Commercial banks could now get into investment banking. Nice. This clip from 1999 reminds us that Senator Byron Dorgan (D-ND) saw a market collapse around the corner, even if he didn't know exactly when it was going to happen ...




The fact that we haven't done anything to bring back Glass-Steagall is just one of the reasons it's easy to argue that we're going to have another 2008 market collapse, again.

- Mark

BANK FAILURES UP

A little bit over a year and a half ago I wrote that more bank failures were coming. Here are some numbers (FDIC list of banks here).

* In 2008 25 banks failed (the market collapse didn't start until late 2008).

* In 2009 140 banks failed.

* To date, this year we've had 118 bank failures.

Since we're only 3/4 of the way through 2010 we should expect bank failures this year to exceed 2009. The real problem, however, seems to be the number of banks that are on the FDIC's Problem/Watch List. This number has gone up from 65 in 2007, to 171 in 2008, to 416 in 2009, and 829 to date in 2010.

Read into this what you want. But rest assured, this is not good news.

- Mark

ADDENDUM: Here's a video from newsy.com that touches on the topic of bank failures. The piece discusses whether current events are a sign of a market correction (a move towards a new equilibrium) or a sign of a slowing economy.

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NASCAR & SPEED RACER HELP EXPLAIN HOW FINANCIAL REFORM FALLS SHORT

It's no secret that NASCAR got it's start back in the days of prohibition. Illegal moonshiners and whiskey runners, trying to outrun the law, would find ways to make their cars faster than those of the local police. And they did. Today's NASCARs are marvels in mechanical engineering.

While the cars have gotten faster, the vehicles used on the NASCAR circuit aren't allowed on our public streets for a reason. They're too damn fast, and they aren't up to code (though they can withstand a crash better than the average car). In fact, laws on the books prohibit you and I from tampering with our cars in ways that would make them too big or too fast for public roadways because of the temptations and affiliated dangers that come with having access to all that speed and power.

It doesn't matter if you are a professional racer, over time even the best can crash and burn. Worse, they will take even good drivers out with them.

When you do get car that can outrun the police speeding laws, the highway patrol, the flow of traffic, etc. all work to keep you in check. Put another way, as much as Americans love NASCAR and going fast, we all understand that you can't have people running around driving like NASCAR drivers in suped up automobiles. Even Germany's famous autobahn has 'coercion' and other rules that are enforced by the autobahn police.

This is what makes the current financial reform legislation so frustrating. We know that having "too big to fail" (TBTF) financial firms isn't good for the nation. We saw this in 2008. We saw variants of this in 1987 and in 1929. Yet the current financial reform bill being discussed in Congress does little to nothing to rein in the stupidity and greed we saw before 2008 by the TBTF banks. Indeed, private bank analysts are even suggesting that the financial reform bill won't have any teeth at the end of the day.

It's as if, after causing a series of epic crashes on our nation's highways, we said ...

... "No problem, let's allow the NASCARs, the muscle cars, and other Speed Racer wannabes out on the public road ways. They're good 'ol boys anyways. Nothing's going to happen. We can trust them, this time."

Then we have the fact that the financial reform bill does little to nothing to stop the big banks from trading in highly speculative derivative products, with taxpayer backed (FDIC) money. In a few words, banks can continue using your money deposits - which are government insured - to make market bets that only the banks profit from. If the market tanks, and the banks go under again (and they will), it's you and me the FDIC who has to come in and save the TBTF banks, again (under the guise of insuring your money, of course).

And, No, the provision in the finance reform law that says banks will be liquidated and the executives will be fired if they go belly up (again) is no real safeguard. There were already provisions for this to happen. We didn't use the law in 2008 because ___________________ (fill in blank). What makes us think we'll use it the next time? Because we learned our lesson after 2008? Give me a break.

The financial reform bill currently making it's way through Congress essentially tells all the financial Speed Racer wannabes, "Don't worry. If you crash, or make other people crash, we'll pick up the tab through our 'Speed Racer Wannabe' insurance program" (otherwise known as FDIC).

Look, at the end of the day, if you want to supercharge a car and race it you can always go to a local speedway on the weekend, or beome a professional and join the circuit. The point is, you're the one on the hook for your need for speed. Similarly, if you want to claim to be a super capitalist because you make supercharged market bets you're supposed to use your own damn money. And then you're supposed make market bets in a way that affects only you when your bets don't pay off.

Is this really hard to understand?

- Mark

OUR VIVA LAS VEGAS ECONOMY . . . ELVIS HASN'T LEFT THE BUILDING

While all the pundits seem interested in what's happening in the various primary races around the country today the reality is we still need to deal with the issue of America's banksters getting too big to fail (TBTF), and the fact that they're making bets like they're in Vegas with no adult supervision. Here's what's happening.

From TBTF to an Oligarchy of Interests
Back in September 2009 Thomas M. Hoenig, the 63-year-old president of the Kansas City, Federal Reserve Bank spoke about the need to rein in our increasingly TBTF banks. Because of the bailouts and the fact that the Federal Reserve has encouraged merging failing institutions with healthy ones Hoenig noted that "the top 20 banks own 70% of the [banking system's] assets." In many ways it's much worse. The top four banks in America (BofA, JPMorgan-Chase, Citigroup, and Wells Fargo) now control $7.5 trillion in assets, which accounts for more than half (52%) of our nation's total economic output for the year.

According to Hoenig, by dumping billions in taxpayer bailouts and guarantees on the banks - with virtually no questions asked, and no new restrictions - the federal government has effectively removed the threat of receivership, bankruptcy and disgrace from their horizons. This, not surprisingly, has had the effect of conferring special status on America's biggest banks.

So instead of finding themselves in receivership, and seeing their top executives fired for incompetence, our TBTF banks have become the new aristocracy of corporate America, perpetuating "an oligarchy of interest" ... that only benefits themselves.

Wait, It Gets Worse
Apart from removing the threat of bankruptcy from our nation's biggest institutions financial horizons, we have another, bigger, problem to deal with. Banks are making bets on derivative contracts at record levels, with money they didn't earn and, worse, with less than stringent capital requirements. First, the record levels ...

Immediately after the market collapsed in September 2008 the notional value of derivative trading (the stuff that got the banks in trouble) dropped by almost $7 trillion dollars, to $149 trillion, according to the FDIC. The reason was simple. In a few words, the banksters got spooked.

But once the banksters got Congress the American Taxpayer to bailout their stupid bets at 100 cents on the dollar things began to look up. The banksters went wild. Just one year after the September 2008 market collapse the notional value of derivatives traded by the banksters surged $31 Trillion, and reached $191.2 Trillion by September 2009 (that's more than 13 times our nation's GDP for the year). 

Guess who's making the most derivative bets trades according to the FDIC? Yup, it's the biggest TBTF banksters who own most of our nation's financial assets.

Better yet, take a guess what our biggest banks are betting trading on? Small business loans? Home loans? Corporate loans? Neighborhood development contracts? Not even close. They're betting on interest rates (90%) and foreign exchange contracts (8%). That's right, according to the FDIC, 98% of what they're betting trading on is the price of money in the future ... money that you and I provide them with our tax payer dollars.

Wait, it Gets "Worser"
Until 2004 the financial industry's "net capital rule" restrained brokerage firms to debt to equity ratios of 12 to 1. But then the Securities and Exchange Commission (SEC), as per their regulations, met to consider a request by Merrill Lynch, Goldman Sachs, Lehman Brothers, Bear Stearns, and Morgan Stanley. The request was very simple. Led by then CEO of Goldman Sachs, and future Treasury Secretary, Hank Paulson, the firms wanted the SEC to allow them - and just them - to lift their debt to equity ratios so they could borrow and trade more (on derivatives).

In a few words, for every dollar these firms had and traded they wanted to bet & carry more debt on the books. The SEC granted them their request and, as you can imagine, the brokerage firms went nuts on derivatives (almost doubling the amount of derivatives traded by the time the market collapsed in 2008).

Bear Stearns and Merrill Lynch, in particular saw their debt to equity ratios jump beyond 30 and 40 to 1 respectively. For those of you doing the math at home, this would be akin to someone making $50,000 per year and the banks allowing them to borrow and carry $1.5 to $2 million in debt ... which they then used to gamble in Vegas!

Since the market meltdown you'll be happy to know that little to nothing has been done to alter our Vegas economy environment. Leverage (debt) and "net capital" (asset) requirements remain virtually unchanged. My friends, Elvis has not left the building ... the party continues.



- Mark

Addendum: As long as I'm bringing up Elvis (and since he's still cool), I might as well include this song, because it reminds me where our banksters should be.

MARKET DELUSIONS RUN DEEP, II

A couple of days ago a friend sent me this market analysis, written by two economists, who explain why Wall Street wanted to suspend market prices on certain products. This practice, which suspends the "market-to-market" (MTM) accounting method, essentially allows market players to reprice an asset that they hold if it's generating income, even if the underlying asset is under water (akin to a homeowner making payments on a house that is not worth what they owe on it).

The logic behind suspending market prices is to help keep those who "own" the product from having to provide more cash or collateral to backstop the asset. The idea is to prevent fire sales on Wall Street. All things being equal, this is a good idea.

But all things aren't equal.

I wrote about this on Friday, and made it clear that the suspension of MTM effectively allows the financial sector to suspend reality. Among the many concerns I have is that suspending MTM is being done for the wrong reasons, with virtually no strings attached, and with plenty of government guarantees. It virtually invites another market collapse.

MARK-TO-MARKET’S A RED HERRING
As Bloomberg’s David Reilly points out, MTM is little more than a diversion employed by America's biggest financial institutions “to dodge two big issues -- their reckless use of borrowed money to boost returns and their inability to make sound loans and investments.” According to Reilly, of the $8.46 trillion in assets held by the 12 biggest banks before the meltdown, only 29% of it was something that could be marked to market. In some cases it wasn't even that at that level. General Electric Capital - which is similar in size to the sixth-biggest U.S. bank - said that just 2 percent of it's assets could be marked to market.

What’s really dragging down the banks? According to Reilly, its loans made to consumers, businesses, and other institutions. Because loans for cars, credit cards, and other activities are held at their original cost, when they fail to pay out they act as a drag on the banks. When this happens they need to come up with more collateral, or loan loss reserves. The banks didn't have the money. This is what banks were up against.

Put another way, MTM is a red herring that diverted attention form the bad loans banks made.

Real investors know this. They’re worried about the loan portfolios and the bad investments of the biggest banks. Simply put, they didn’t trust what the biggest banks were doing, and where they were lending their money. As Reilly points out,

… the Big Four have a higher percentage of tough-to-value assets due to their investment- banking activities. In many cases, losses that stemmed from those holdings reflect banks’ decision to enter risky transactions or markets. In that case, mark-to-market simply recognizes the reality of those missteps.

The biggest banks were being dragged down by their short-sighted lending decisions and their own stupidity. Mark-to-Market helped expose this.

DUMPING THEIR STUPIDITY ON THE AMERICAN TAXPAYER
Apart from transparency, and exposing the short-sighted decisions of America's financial institutions, why should we continue to use market prices to gauge what a product is worth? Because suspending MTM effectively allows financial institutions to reprice toxic securities. This, in turn, allows them to tell their creditors, their customers, and the government “Look at how much our securities are worth now … we don’t need more collateral or loan reserves … And besides, based on our magically repriced asset, if we want we can get a government guarantee or a government backed loan (through Federal Reserve and Treasury Department sponsored programs).”

I won’t go into the details how this happens (take a look at TALF and Maiden Lane programs to get an idea). Still, it's says much that Bank of America is shoving more and more of it’s “nonconcurrent” (and probably most toxic) loans on to the backs of the American taxpayer.

Consider the following. Last year, only 2.7% of BofA’s failing loans were backstopped by the American taxpayer (student loan guarantees, etc). Today over 20.5% of BofA’s $61 billion bad loans are now the responsibility of the American taxpayer. Take a look at the numbers.

I can't tell (yet), but it seems to me that BofA is doing this because they’re now able to tell the government, “These loans aren’t really bad because the underlying asset is still worth $100 million. See, we just repriced the asset.”

Yeah, and watch me pull a rabbit out my hat … nothing up my sleeve. 

At the end of the day, MTM is not the real problem. The problem is how much banks borrowed against assets whose prices have collapsed. I'm not sure, but it seems to me that suspending MTM was just another way for America's biggest financial institutions to reprice assets so they could dump them on the government through taxpayer funded guarantees.

OK, SO WE SUSPENDED MARK-TO-MARKET
OK, so the Financial Services Accounting Board (FASB) suspended MTM last April (2009). This could be a good thing. Franklin D. Roosevelt did it, so it can't be all that bad, right?

What we've forgotten is that FDR backed away from MTM because he had other programs and regulations in place (or being put in place) to help insure that suspending MTM wouldn't get out of hand ... or lead to excessive borrowing, inflated books, or wild speculation in other areas. What this tells me is that if we're going to take market prices out of the market, as FDR did, we should also reinstate the 1933 Glass-Steagall Act, which kept commercial banks, investment banks, and insurance companies away from each other's business.

While we're at it we should also repeal the Federal Reserve's 3-2 decision in 1987 that allowed commercial banks back into the securities' market in a big way. We should also put some teeth into the Securities and Exchange Commission, pare back FDIC guarantees, limit brokered deposits, do something about credit default swaps, repeal FANNIE MAE's privatization, and put some teeth into limiting GSEs. And, for good measure, we should have brought back HOLC (instead of President Obama's disasterous, and bank-driven Making Home Affordable Program) and bolstered the hand of labor.

The point is, FDR suspended MTM only because there was a regulatory framework in place to help insure the stupidity we saw in the run up to meltdown in 1929 (and 2008) did not occur.

CONCLUDING COMMENTS ON MARK-TO-MARKET
At the end of the day, the market analysis from the two economists got it wrong. Bringing MTM back in 2007 didn’t cause the market to collapse. It simply exposed the market stupidity that was going on after we deregulated the markets.

Look, I have no problem with suspending MTM, like FDR did. But if we're going to suspend MTM, and channel the legacy of FDR in the process, we should also bring back FDR-like programs which worked to insure that bubbles and other market stupidity didn't get out of hand in the post-war era.

We want to keep in mind that one of the reasons that market players were able to create such fabulous "wealth" over the past 20 years was because no one really knew how much some of the instruments they created were worth. But their computer models did. This helps explain why so much toxic, over-leveraged, debt was created. Market players were living in a market world governed by computer models rather than the logic of the market. MTM helped expose this fairytopia.

Simply suspending MTM, without calling for the regulatory infrastructures (especially related to over leveraging) that helped make our economy such a success in the post-war era, is like throwing a group of kids into a candy store and saying "Do what you want, but don't eat too much". Without rules, things will get out of hand.

What many ignore in all of this is that if our financial institutions hadn't borrowed and lent so much against shady assets - or if they had kept enough capital reserves - they wouldn't be worried about MTM valuations. Hyman Minsky has much to say about this (I'll leave Minsky alone for now; you can read about Minsky in my book, or in the labels below). But in a deregulated environment, where the biggest market players are borrowing and/or betting on assets of dubious value, well ...

Banks and other financial institutions have been making stupid decisions for years. The series of bailouts and subsidies for industry is long and sobering (for my money, much of it starts with the bank bailouts in 1982, and the S&L debacle). What happened in 2008 should have been a wake up call for the industry.

If market players don’t like what they saw once MTM exposed what was happening after 2007 they should act like real market players. They shouldn’t be getting so deep into products that create such a big mess for them, and the American taxpayer. That’s the way real market players deal with uncertainty.

Pretty simple if you ask me.

- Mark

WANT TO KNOW WHY BANKS AREN'T LENDING?

This Money Morning article is by far the best piece I have read about the "brokered deposits" and "hot money" pheonomenon that's challenging our banking and economic system. Simply put, the need to find higher yields with FDIC guaranteed deposits (which bank brokers do), coupled with the need of our biggest bank's to pad their books, helps to explain why bank loans to Main Street have collapsed (in spite of trillions in taxpayer dollars being thrown at the banks).

Students who have been in my American Politics class (and paid attention), and those who have followed this blog, will understand immediately the importance of our current brokered deposits situation. Brokered deposits help to explain why I believe we're gearing up for Round Two of our Economic Meltdown.

If you don't read anything else today read this article. And if you're inspired, you should read this piece from Zero Hedge, which explains how Bank of America is covering their losses with U.S. government guarantees.

- Mark

HERE COMES THE BAR TAB ...

I think one of the great frustrations for most Americans today is that we understand that we're getting screwed. The people who gave corporate America the favorable legislation they needed to wreck our economy, and the idiots on Wall Street who are stealing and looting from the U.S. Treasury, are still singing and dancing on the deck of the Titanic. They're acting as if the financial iceberg we just hit is no longer a concern because Captain Bernanke and his crew at the Federal Reserve think they see land on the horizon.

So Congress continues to play games with regulations that need to be created, or reinstated, while Wall Street continues to extract wealth from the American taxpayer.

Worse, as Tim Iacano at Iacano Reserch points out, we just gave Ben Bernanke another term at the Federal Reserve. We did this in spite of the fact that he clearly demonstrated that he had no idea that the financial icebergs floating in our economic waters before the market meltdown only represented a small portion of what was out there (what we see of icebergs generally represents about 10% of it's total mass).

If anyone needs reminding, this is what Captain Bernanke saw as he was asked about all the financial icebergs before the 2008 market collapse.



Well, hang on to your hats because it looks like we're taking on water again. Only this time it's just you and me, the American taxpayer, who's sitting in the sinking ship. But rather than floating us a life boat - or a yacht, like they gave Wall Street - the Federal Reserve is throwing the American taxpayer an anchor. And it's coming in the form more debt that we're going to have to pay for as we pick up the tab for the stupid decisions made on Wall Street. Here's how it's happening.

If you recall, not only did the Bush and Obama administrations commit $1.5 trillion in the form of TARP and stimulus program money, but the Federal Reserve and the Treasury Department have been working in tandem to commit trillions more guaranteeing and purchasing the failed business contracts that companies like AIG, Goldman Sachs, and Merrill Lynch wrote, but don't want on their books.

So, for example market players (they're not investors) would bundle up hundreds of thousands of debt contracts - car loans, credit card debt, mortgages, etc. - and repackage them as securities. Of course, in the process they paid themselves handsome fees and bonuses for writing these contracts. When they found gullible pension funds, foreign banks, and domestic institutions willing to buy these security contracts they did this over and over again (I say "gullible" because, as Brooksley Born pointed out during the Clinton adminstration - and as the FDIC made clear in 1998 - these markets were far from stable).

Still, as you can see from the graph below, contracts for unsecured or "non-agency" (no Fannie Mae or Freddie Mac backing) mortgage backed securities (MBS) reached over $1.1 trillion in value by 2005, and then climbed to $8.2 trillion in 2006 and $9 trillion in 2008 for all housing related securities.

Along the way came companies like AIG (among others) who insured these securities. And why not? Ben Bernanke was confident that the bank regulators were doing the right thing, "market fundamentals were strong," and housing prices don't fall, right?

Insurance + the sage words of Fed Chair Ben Bernanke helped make those who bundled up debt contracts feel secure. Since housing markets don't collapse why not write more security and insurance contracts, right? As a result, Wall Street and the financial titans of America actively went out and looked for more debt to write up, bundle up, and insure.

When people stopped paying their debts and mortgages (for whatever reason) what should have happened is that those who insured the securities should have paid up. Let me be clear here. When people stopped paying the debts and mortgages that made up the security what should have happened is that those who insured the securities should have paid up.

This is what happens in a real market economy. But it didn't. Why? I'd like to say because we don't have a real market economy. While this is true, in practical terms companies like AIG didn't have the money. In essence, they had been writing insurance contracts for products they didn't have the money to pay out.

Rather than have the holders of the securities that went bad lose their money, or force them to sue companies like AIG for their insurance money, big market players cried "market collapse." Instead of taking their lumps for diving into shaky debt markets Wall Street was able to convince the federal government to purchase, guarantee, or hold their bad deals.

How did they do this?

Between Congress and the President (both Bush and Obama) an environment had been created for the government (through the Federal Reserve) to loan money to the holders of failed or failing security contracts. In return the government the American taxpayer would accept as collateral the toxic securities that companies like AIG were supposed to have insured.

How much of this market crap is the government the American taxpayer currently holding? We're now sucking on trillions of dollars of downgraded and worthless crap. Check this out (don't be fooled by the term "Asset Side"; when it comes to MBSs they're ghost assets) ...

Yes, these trillions add up to much more than the $1.5 trillion President Bush and President Obama asked for and received from Congress. If you want to know what this looks like in real terms, this is what we're looking at ...

In practical terms, unless we do something on the jobs front and with regulations on Wall Street, we're looking at a long recession, higher taxes, inflation, and/or a mix of all three. It's not pretty.

So, the financial mandarins who caused this messs - by diving into debt markets, and insuring toxic crap they couldn't afford to pay out on - are now cruising away on their bailout yachts. You and me, however, are getting stuck with what's left of our debt-ridden ship. The names (Maiden Lane, TALF, etc.) of the bailout programs really don't matter at this point (names, explanations and amounts dumped on the U.S. taxpayer can be found here, with updates here). What matters is that in addition to losing jobs, suffering through pay cuts, home foreclosures, and enduring the uncertainty that wrecks families you and I are going to have to pay the tab for Wall Street's greed and stupidity.

A bunch of arrogant fools create a debt-driven bubble that they led everyone to believe they could manage. Then they dump it all on us, and get rich in the process. Does this seem right to you? 

- Mark

IGNORE REGULATION NOW, PAY (again) LATER

Yves Smith at nakedcapitalism has an interesting post on the new regulations proposed by the Federal Deposit Insurance Corporation (FDIC), the federal institution that insures your bank deposits. The goal is to put some limits on the stupidity and greed that helped bring down our markets, and threaten to do so again (because we've done nothing to alter behavior, and have left the same guys playing the same games).

These three suggestions stand out:

1. SEASON THE LOANS: Make sure mortgages are "seasoned" - or maintained with the loan originator - for 12 months before they can be passed on to other market players (who either packaged or cut up mortgages to be sold elsewhere).

2. REAL BUY-IN: Loan originators must maintain a 5% stake in the mortgage contract after it's sold. The ideas is that if loan originators have a stake, they will write better loans.

3. NO CDOfication: Collateralized Debt Obligations (bundling up loans that are sold as a security) are not permitted.

If these proposals are real I like them, as a start.

Now, I'm sure there are some people out there - like the parasitic sociopaths on Wall Street who got us in this mess - who are probably going nuts over the idea of regulating the market. I say to hell with them.

They should have learned something from the market collapse, but didn't. One thing they haven't learned (nor appreciate) is that, were it not for the trillion dollar bailout, many of the those complaining about financial and security regulations would now be in court fending off lawsuits, or in jail (because the bailout helped fill financial gaps - especially by allowing collapsed securities to be used as collateral for government loans - securities related lawsuits declined dramatically in 2009).

What these parasitic sociopaths fail to understand is that markets don't self-regulate. Market players don't always do the right thing. Consider the following.

Part of what started our economic landslide were unregulated over the counter (OTC) markets. Market players bought and sold complex financial instruments (derivatives) in OTC transactions that few understood, and even fewer could justify as a meaningful contribution to society. These transactions did little more than inflate claims on money between Wall Street power brokers, and created a massive bubble economy. We're now paying for these acts of greed and stupidity in the form of collapsed home values, increased unemployment, rising credit card rates, reduced tax revenue and higher government debt, etc.

How much did they inflate market claims? Brooksley Born, former head of the Commodity Futures Trading Commission (CFTC), said that by June of 2008 trading on the OTC markets surpassed $680 trillion. How big is this amount? The total amount of goods and services the U.S. is expected to produce this year is worth around $14 trillion. Six hundred and eighty trillion dollars, according to Born, is more than 10 times the gross national product of all the countries in the world, combined.

The worst part of this is that market players (they're not investors) were gambling with borrowed money, and providing insurance on products that they could not pay claims on because they didn't have enough capital on the books. One of the few people who saw what was happening in the 1990s and tried to do something about it was Brooksley Born. For her efforts - to secure information (which started with a concept release) and regulate the OTC market - Born  was beat up politically, and effectively muzzled, by Alan Greenspan, Bob Rubin, and Arthur Levitt.

You can read about Born's warning here, or you can watch "The Warning" on Frontline here. It really does a great job of explaining what we're up against. What's clear is that we can ignore the calls for regulation now, or pay (again) in the future.

- Mark

MARKET CHEERLEADERS LIVING IN FAIRYTOPIA

Back in March I got into a rather interesting e-mail discussion with one of the economists at Merrill Lynch (in New York). It came after I read one of their monthly newsletters, where the authors presented the world with what they thought was sound market analysis. It was garbage, and I let them know.

Well, hang on to your hats. We're now getting more and more of the same garbage, as you can see in this "It's Not the Government's Recovery" piece by Brian S. Westbury and Robert Stein. The authors do their level best to show the world that people in the bailed out financial sector (like them) know what they're doing when, in fact, they don't get it. In my view, they have no idea about cause and effect relationships when it comes to our current market environment.

Check this out.

The authors first claim that accounting gimmicks like "mark-to-market" - which allows the financial sector to reprice garbage - have made things better. And it did ... for market players on Wall Street.

What the authors don't mention is that the freedom to reprice their garbage came in the bailout language signed by President Bush after Newt Gingrich and the financial industry lobbied Congress extensively (here's what I think about mark-to-market), while others worked on FASB rules. This means that the federal government altered the rules for the industry to help revitalize collapsed market prices. There were no invisible hands here as the authors suggest.

Then the authors argue that "easy money and the the normal tendency for free markets to heal from panic" created the conditions for recovery. This is truly pathetic.

Look, I voted for President Obama and genuinely want him to succeed. But the recovery isn't real (no matter what Larry Summers says). Those of you who read this blog regularly know why. To the extent that things may have stabilized, the "easy money" policies (via low interest rates) that made this possible were mandated/facilitated by the Federal Reserve. This occurred with the cooperation of the White House and the Treasury Secretary. This is government policy.

Finally, the authors also hide behind industry junk terminology ("V-Shaped recovery", "monetary velocity," etc.) that, I'm sure, impresses gullible family members and drunk neighbors. But it does little more than camouflage reality. It completely misses the multi-trillion dollar guarantees that the Federal Reserve, the FDIC, and the Treasury Department created for Wall Street's market garbage. This along with mark-to-make believe are what is creating the illusion that things are picking up on Wall Street (by facilitating counterparty payoffs). 

At the end of the day, what Westbury and Stein present is stunningly superficial and myopic. It really belongs in the Irving Fisher School of Permanent Plateaus. More to the point, to suggest that markets are "healing" because of some kind of Magical Market Pixie Dust is simply delusional.

There's more from the authors (including the incredibly ignorant suggestion that the "economy would be doing even better ... if government had stayed out of the way") but it's clear that Westbury and Stein really have no clue what's happening in the economy. These guys are living in a free market fairytopia.

That they're writing this stuff, and people take them seriously, should be a Red Flag. They're cheeleaders, not analysts.

- Mark

PAUL VOLCKER'S THE MAN (and Reagan Blew It)

In 1987 the Federal Reserve Board voted 3-2 to allow commercial banks to underwrite (invest in or accept some of the risk for) a limited amount of financial instruments like municipal bonds and mortgage backed securities. Underwriting bonds and securities had been a problem before the Great Depression because banks took depositor money and jumped into bigger and riskier investment schemes. As is the case today, bankers got greedy and stupid. Funny how some things never change.

Anyways, when bond markets and security investments tanked in 1929 banks who had taken bigger and bigger risks collapsed and took their depositor's money with them. There was no Federal Deposit Insurance Corporation (FDIC) back then so ordinary depositors lost their money to the stupid deals bankers made. You know the rest of the story.

Fast forward back to the Federal Reserve's 3-2 decision in 1987 ... By allowing our FDIC-insured banks to take on the risk of underwriting securities the Federal Reserve opened the door that would eventually enable our FDIC-insured commercial banks to get involved in the financial crap (CDOs, MBS, CDS, etc.) that brought down our economy last year. This is important to know because one of two board members who voted "no" on the 3-2 Fed decision was then Chair of the Federal Reserve, Paul Volcker.

I provide this background because Paul Volcker once again is doing us all a favor, which will probably go unnoticed (again). Via nakedcapitalism.com we learn that while in Sussex, England Mr. Volcker gave a speech and told some of the world’s most senior financiers that their industry’s “single most important” contribution in the last 25 years has been automatic telling machines, which he said had at least proved “useful”. Imagine, telling a group of financial executives with big wallets - and even bigger egos - that their greatest gift to humanity over the past generation was ATMs. Beautiful. But he didn't end there.

Mr. Volcker then went on to tell the group - after being asked about the importance of securities - that the commercial banks could innovate all they want "but do it within a structure that doesn’t put the whole economy at risk." The real surprise here is that many in the crowd were "stunned" by his common sense approach to banking.

Mr. Volcker finished by saying the industry needed to "wake up" and that investment banks and hedge funds should be the only financial groups taking on high risk investments. He added that our governments should also be telling them "If you fail, fail. I’m not going to help you. Your stock is gone, creditors are at risk, but no one else is affected."  That this even needed to be said - and that anyone would be offended or "stunned" by the suggestion - says much about where we're at today.

And, for those of you keeping score at home, Ronald Reagan effectively fired Paul Volcker and replaced him with Alan Greenspan. You do the math.

- Mark

BofA RETURNING BAILOUT CASH ... IT'S SMOKE & MIRRORS

In an effort to get out from under the watchdog eyes of the federal government Bank of America is re-paying $45 billion in TARP bailout money. Sounds like great news, huh? The "road to recovery" others will argue. Well, hang on to your wallets. It's all smoke mirrors ...

QUICK OVERVIEW
BofA is saying that they will use $26.2 billion of its own money, and $18.8 billion in raised capital (for a total of $45 billion), to pay down what they borrowed from the Troubled Asset Relief Program (TARP). Where have they gotten the $26.2 billion? This is especially a good question since they were moving toward financial Armageddon after purchasing the very toxic Merrill Lynch just 9 months ago. BofA is getting the money from at least three developments:

* TAPPING RAINY DAY FUNDS

* BAILOUT FUNDS TURNED STRAW INTO GOLD

* CONTINUED GAMBLING

I'll take each one in turn.

TAPPING RAINY DAY FUNDS
BofA, like all other FDIC-backed financial institutions, has reduced the amount of money they are putting aside for a rainy day (blue line on the chart; called Coverage Ratio). As The Pragmatic Capitalist points out (in "The Bank Profit Mirage"), this means that if things go bad in some client accounts banks will have less money to deal with the problem than they did before the market collapsed last year. How do we know this? Because the FDIC keeps track of this stuff. Again, look at the Blue Line on the chart.

But then it gets really bad. Every time somebody decides that they can't make payments on a home loan or a small business loan it becomes a non-performing loan. Look at the red line on the chart (Non-Current Loans & Leases). As you can see, things aren't going well for American debtors these days. When BofA (or any bank) decide they can't squeeze any more money out of a debtor they simply write the account off as a loss (or a "charge-off"). Things aren't going well here either. Look at the green line in the chart (Loan Loss Reserves).

You don't have to be a rocket scientist to see things aren't going well for FDIC-insured banks.

Most institutions are supposed to have money to cover accounts they anticipate will go bad. After last year - and given current economic conditions for Middle America - you would think that banks would be putting billions more into the Blue Line (Coverage Ratio, to cover anticipated losses). They're not. Instead of using billions as operational (rainy day) funds they're shifting them over to their bottom line and calling it a "profit."

And just like that, it looks like banks are doing better. See how easy that is?

In a few words, BofA is taking billions out of it's rainy day fund at precisely the time that they should be putting more into it. My guess is that they're confident that their current market bets will continue to pay-off because of government guarantees in other (non-TARP) areas. Here's why.

BAILOUT FUNDS TURN STRAW INTO GOLD
I'll try and make this as simple as possible. The once toxic derivatives, and other market garbage, that Merrill Lynch, Goldman Sachs, and AIG (among others) had were suddenly cleansed. Because of the federal government's bailout money, the Federal Reserves gurantees and credits, and the Treasury Department's intervention, well over $5 trillion in watered stock, bad assets, and toxic securities were pretty much cleaned up by the U.S. government. I previously wrote about this in my "Iron Maiden" posts.

These financial cleansing activities by the Federal Reserve and the Treasury Department covered at least $1.9 trillion for new lending and $4.8 trillion for troubled asset purchases. They also explain why Goldman Sachs, Merrill Lynch, AIG, etc. were suddenly made "profitable" to the point that they could pay out 100 cents on the dollar. Everything they thought was toxic was suddenly turned into gold.

In a few words, banks are profitable because the American taxpayer has made them profitable through Federal Reserve and Treasury Department trillion dollar guarantees. If our financial institutions, like BofA, were really doing fine they would pay back the TARP money and then ask the Federal Reserve and the Treasury Department to rescind their trillion dollar guarantees. But they can't. They need the guarantees to make money off the toxic assets they're still flushing out of the system. This is not a sign of recovery.

CONTINUED GAMBLING
As I pointed out two posts ago one of the reasons financial institutions are starting to see profits is because they've gone back to the same derivative markets that helped get us into this mess. Rather than making loans to small businesses and entrepreneurs (who take longer to pay off) financial firms like BofA are betting on making a quicker buck on derivative contracts. This "recovery" strategy - as any half-wit should see - is only working because of the trillion dollar Federal Reserve guarantees and Treasury Department interventions.

Gambling with a continuous stream of the House's money does not make you a success ... no matter how much you make. In fact, it should make you the butt of the gambling den's jokes. But that's not the case for America's financial institutions. They actually believe they're the ones making things work.

FINAL THOUGHTS
The additional $18.8 billion that BofA says it will use to pay it's TARP loan back will come from selling more of it's stock. This means BofA will dilute the value of current shareholder stock in order to raise capital. This is not good news for their shareholders. But the goal isn't to appease shareholders today. It's to get the U.S. government off of its back so that BofA

At the end of the day, that anyone buys into the idea that the major financial institutions are healthy is dumbfounding. Toxic assets were spun into gold by the U.S. government. Money (or "profits") used by BofA to pay back the federal government is really operational capital that should be used for the rainy day around the corner. Instead, BofA, like other financial institutions, is banking on the Fed's trillion dollar guarantees to make anticipated losses whole. But this is understandable. Federal Reserve trillion dollar guarantees don't have TARP-like conditions attached to them (thank you Tim Geithner and Ben Bernanke).

Finally, that BofA and other financial institutions continue to bet on interest rate and foreign currency derivative markets - which have been made whole by government money - should be a red flag. The fact that the media wants to talk about the "recovery" of BofA, instead of asking why they're so healthy, tells me one thing: We've learned nothing from the previous years of smoke & mirrors.

Stay tuned.

- Mark

BANKS, BETTING THE HOUSE ... AGAIN

Remember how the derivative market helped get our financial institutions into trouble, and then helped collapse our economy? Well, after handing over trillions of dollars in taxpayer guarantees, loans, and credits to cover the derivative losses of our financial institutions derivatives are making a comeback.

After watching the value of derivative contracts drop to a little over $100 trillion at the end of 2008, our failed financial institutions are writing more derivative contracts than ever. According to the FDIC the total value of derivative contracts has now reached about $135 trillion. To give you an idea of what this means $135 trillion represents almost 10 times what America will buy and sell this year (2009 GDP Forecast for America = $14.26 trillion).

Check out this derivative graph (click on all the graphs to enlarge):

For those of you still having trouble with the concept of a derivative let me make this simple. They are contracts that derive their value from something that hasn't happened yet. I know, I know ... it's still kind of fuzzy. So, think of a scalper who buys tickets and creates a game package.

For example, scalpers who gamble and buy tickets and then rent hotel rooms for this year's Super Bowl are now hoping that the undefeated Colts and undefeated Saints continue the pace all the way to the Big Game. Every football fan will want to be there. But what if things sour for the Colts and the Saints? Let's say that the Houston Texans and the Carolina Panthers somehow stumble their way into the Big Game as 9-7 teams. Guess what? You're probably looking at a loss. You're especially in big trouble if you purchased lots of tickets and rented lots of rooms. But you're really REALLY screwed if you made purchases or made payouts with the anticipated profits from an undefeated Colts-Saints Super Bowl.

In the real world this is what happens when you spend money (make bets) on products (game tickets) that "derive" their value from events that must happen (Colts-Saints going undefeated all the way to the Super Bowl) for a payout.

But big finanical institutions and commerical banks don't live in the real world. They live in an Alice in Wonderland Economy, courtesy of you and me. They have learned that they don't have to worry about being criminally stupid. The American taxpayer will bail them out, with no penalty to alter behavior.

Must be nice.

Today the same commercial banks that helped bring this economic mess upon us are making bets on the direction of interest rate contracts and foreign currencies, once again anticipating big payouts. So what are they banking on, you ask? A couple of things. Here we see they're betting on $188 trillion in foreign currencies and future interest rates.

Let me say this again. Rather than try and make money by lending to small business and entrepreneurs who will create jobs our biggest commerical banks are upping the ante and making trillion dollar bets on the direction of interest rates and other currencies. And they're able to do this because Tim Geithner, Ben Bernanke, and Hank Paulson did not pushing for penalties and new guidelines for our bailed out financial incompetents when we handed them their cash.

As a final insult to the American taxpayer, who financed the banking bailout - and who are now struggling to pay the bills - commerical banks have cut back on consumer credit. They've cut over a trillion dollars in credit card lines over the past year.  Check this graph out ...

Worse - as if it could get worse - among the "derivative contracts" that our financial titans are betting on include the mortgage and credit card debt that you and I are now paying. In a few words, they are betting that you and I will keep paying our bills. They have turned our debt into "debt contracts" that they've bundled together (as CDOs) and sold to one another. They are now betting that we will pay no matter how much they raise interest rates (which they are confident about, in part, because of the 2005 bankruptcy law changes).

So, this is what we have: (1) You provide the reliable and secure debt contracts with your steady mortgage and credit card payments; (2) You provide the taxpayer money to guarantee bailouts on the stupid bets our financial institutions make; and (3) The banks continue betting like the greedy drunken fools that they are with no penalty for past stupidity. What could possibly go wrong?

There's more. Much more. So check out this FDIC site on "Commercial Bank Graphs and Data Points." It's not pretty.

- Mark

IRON MAIDENS & OUR MEDIEVAL-LIKE FINANCIAL RESCUE

Of all the "fun" things humanity has figured out the prolonged and brutal torture of each other seems to be among the most creative of our efforts. Among the many tools that we've concocted include the Iron Maiden. While there were many variants, one iron cast model, like the one shown here, was built to follow the general contours of the human body.

In this model, a hinged front door allowed torturers to put their subjects in, and helped keep them upright. Generally there was a small opening around the face so that the torturer could interrogate their victim, and hear their confessions (they usually confessed), with knives and nails fastened securely on the inside for maximum effect.

Often times slits were placed throughout the Iron Maiden so that the torturer could continue to pierce and/or kill their standing target at their discretion. Most often the slits were placed, by design, so that they would miss important organs which allowed for slower death and greater pain and suffering. These little toys of humanity worked so well that even Saddam Hussein's son, Uday, had one. But, apparently, it didn't look like this one ...

I bring all of this up because it would appear that the financial mandarins of America are not only afraid of having their emergency treasure chest of TARP money dry up, but that they have assigned the name "Maiden" to the institutions they created to help transfer money to the failed financial sector. How appropriate.

More specifically, as Willem Buiter pointed out about seven months ago, the Federal Reserve created three "Maiden Lane" corporations. If we cut through all the legalese, at the end of the day these institutions forcefully extract and transfer money from the American taxpayer to America's collapsed financial institutions. For this reason I think it would be more appropriate to call these institutions Financial Iron Maidens, or Iron Maiden Lanes.

Instead of extracting confessions - and under the authority of 13(3) of the Federal Reserve Act - today's Financial Iron Maidens are forcefully extracting money from the American taxpayer ... and lots of it ($23.7 trillion to date). And like the Medieval model, modern day Financial Iron Maidens are propping up dying entities.

In real simple terms Iron Maiden Lane I made the debts of Bear Stearns good by taking Federal Reserve funds (i.e. taxpayer money) and using them to replace the toxic assets Bear Stearns had on the books. Iron Maiden Lane I then handed the cash over to JP Morgan Chase whose "innocence" in this mess, as we all know, made them prime candidates for taxpayer money.

JP Morgan Chase executives celebrated like any Grand Inquisitor who got what they wanted by giving each other bonuses and jacking up the credit card rates of America's card holders. American taxpayers, for their part, are getting the functional equivalent of this ...

Things worked out so well for JP Morgan Chase that Iron Maiden Lane II (for AIG loans) and Iron Maiden Lane III (for AIG default swaps) were created and used to make hundreds of billions in toxic and failed AIG contracts whole. If the market continues to slowly collapse we just might have to bring out the "skull splitter" ...

Good times. Whoever thought the instruments of torture could be so educational?

- Mark

GREAT DEPRESSION ANNIVERSARY

Today is the 80th anniversary of the Great Crash in 1929. What have we learned? Plenty, if we understand what FDR's regulatory regime did for the country (the post-war economic boom was the strongest and most egalitarian in human history). But we started to forget those lessons by the 1970s, and pretty much got a collective case of amnesia by the time Ronald Reagan came to office. We are paying the price for forgetting those lessons today. The HuffingtonPost.com has a collection of articles on what we've learned from a number of writers (some good, some not so good) here. I've attached the piece done by Congressional Oversight Panel Chair, Elizabeth Warren, because it's succinct and spot on.

The Great Lesson
By Elizabeth Warren

Historians generally focus on the October 29, 1929 stock market crash as the triggering event for the Great Depression. But the story has a longer arc.

From 1792 through the Great Depression, booms and busts followed each other like day follows night. But President Roosevelt and the New Dealers had an innovative idea: regulation might tame the boom-and-bust cycle. So they created a new Securities and Exchange Commission to bring some discipline to the financial markets, established the Federal Deposit Insurance Corporation to make it safe to put money in banks, and passed the Glass-Steagall Act to separate ordinary banking from high-risk financial speculation.

America was protected from another financial crisis for almost 50 years. But in the late 1970s, we began to pull the threads from our regulatory fabric, overturning laws and cutting enforcement. The results were the S&L crisis, Long Term Capital Management, Enron, and now, the subprime mortgage meltdown.

There are signs that we may have learned our lesson. Last week, the House Financial Services Committee voted for a new Consumer Financial Protection Agency that would consolidate scattered and ineffective consumer credit regulations and establish a home in Washington for policymakers dedicated to rebuilding the middle class. Other reforms are also starting to move.

The banking lobby is as powerful and deeply entrenched as ever, but it was powerful in the 1930s, too. Nonetheless, the New Dealers learned the Great Lesson: Powerful insiders cannot be permitted to write the rules, and prosperity and security depend on a playing field that supports a vibrant middle class. Today, we face a similar set of questions as we faced then. Will the institutions that created the crisis continue calling the shots and writing the rules, or will Washington take the side of families? Have we learned the Great Lesson?

Elizabeth Warren is chair of the Congressional Oversight Panel created to oversee the banking bailouts and first proposed a new federal agency for consumer financial products in 2007.

- Mark

BAILOUT MASTERS ... "GENIUS"

I've always gotten a kick out of these cartoons ...



I especially like this today because Wile E. Coyote helps explain what's really happening with our bailout plan, and how it's currently blowing up in the face of the American taxpayer. Here's how it's happening.

As the Federal Reserve and Treasury Department continue to shove free money and loss guarantees on Wall Street financiers, they seem to believe that the appearance of "recovery" (in the stock market) and small returns ("As Banks Repay Bailout Money, U.S. Sees a Profit") make them genius-like. They did, after all, "save the world" from economic disaster.

What's not discussed in these "save the world / we're making money" narratives is how the U.S. taxpayer is now on the hook for trillions of dollars in loss guarantees ... which were generously offered up by the Federal Reserve and the FDIC. Why is this important? Because, as Mr. Wile E. Coyote found out, the finaciers don't have to worry about the toxic assets on the books because they're just dumping them off - or funneling them back - on to the federal government (see Wile E. Coyote clip if you're having trouble understanding how this works).

Apart from the Fed and FDIC guarantees, we shouldn't lose sight of the fact that at least one source has made it clear that even if the banks are paying back $4-12 billion that the banks are still in the red to TARP for $148 billion. This means that every American is still taking it on the chin financially (about $1,200 each). Still, we are being told that "it's all good."

Finally, we want to keep in mind that one reason (perhaps the only reason) the banks are returning some of the TARP money so soon is really tied to greed. As TARP recipients, paying some of the money back is the only way they can start giving out the bonuses that they've "earned" over the past year.

I suspect that once the bailout funds dry up that this thing will blow up in our face again. Genius, indeed.

- Mark