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WALL STREET RISK-TAKING AND PUBLIC GUARANTIES

February 7, 2015

WALL STREET RISK-TAKING AND PUBLIC GUARANTIES

My followers know that my political instincts do not lie with Republicans, though they would have during the progressive era of the Republican Party of Lincoln and Teddy Roosevelt when the Democratic Party was old guard, out of ideas, racist, and doing nothing for ordinary Americans. The two parties have since morphed into polar opposites of their former positions on important issues, i.e., the current Republican Party’s leadership is old guard, out of ideas, racist, and is doing nothing for ordinary Americans, preferring instead to cozy up to the superrich and their deep pocket “campaign contributions” (called bribes in my day) and economic ideas that were popular during our Gilded Age when both our government and our country were on the edge of plutocratic ownership. Some of the abuses of the Gilded Age were slowed or ended by adoption of the Sherman Anti-Trust Act of 1890, a piece of reform legislation that today’s Congress would never allow out of committee to the floor in pandering to the wishes of its new plutocrats, those of the corporate class, especially the investment and banking sectors, rather than acting in the best interests of ordinary Americans by voting for reform.

Given this background, it will perhaps surprise my followers to learn that my disdain for what Republicans are doing (and not doing) these days does not extend to all Republicans. I am very impressed with the former Chair of the Federal Deposit Insurance Corporation, Sheila Bair, a Bush appointee and a Republican, who served in that position from 2006 to 2011. She has recently emailed me a message to join her and Americans for Financial Reform in garnering public support to pressure the Fed and other banking regulators to increase capital requirements for Wall Street banks and other financial institutions “too big to fail.” I immediately forwarded such invitation to a selected group of my followers in the hope that they will join me in joining this bipartisan movement.

To those reading this essay who think such a movement is academic and mundane and of little consequence, hear this: If we allow a continuation of the present system of leveraged funding for Wall Street banks to continue at the sometime rate of a ratio of 30 to 40 to 1 of the banks’ own money where the borrowing may be from FDIC-insured deposits as well and there is a global downturn (especially since we now have the unimaginable sum of $1.25 QUADRILLION in derivatives floating around the global marketplace) and now that we are back in bailout territory thanks to recent Republican changes in the Dodd-Frank Act, a world-wide depression or (alternatively) debt forgiveness on a massive scale that would disrupt international capital markets for years to come could be in the offing. To those who may think calling attention to such a possibility is academic and mundane and of little consequence, I would respond that it is the equivalent of atomic war in global finance and is hardly mundane and of little consequence. We are not talking politics as usual; we are talking survival.

Let’s flesh out the need for such a lid on Wall Street leveraging excesses from a summary of Ms. Bair’s invitation. Big banks should not be asking taxpayers to bail them out, and they should not be leveraging funds for investment in derivatives and other shaky deals (see junk bonds and other sovereign debt around the world) from borrowings of funds which may themselves be FDIC-insured (which puts taxpayers at additional risk). The markets should work as markets work, i.e., private investors should accept the risks and take the losses rather than the “heads I win, tails the public loses” practices we saw during the recent financial crisis where some banks and other “systemic” institutions were allowed to reap the profits of their risk-taking but turn to taxpayers for help when those risks turned sour.

Wall Street banks and other such large financial institutions profit by relying primarily on borrowed money instead of shareholder equity to fund their loans and investments and the market (correctly) views them as implicitly backed by the government (see bailouts), so it is cheaper to fund such loans and investments with debt rather than equity. Executives of the banks through such high levels of leverage are thus able to increase their returns on equity (and their bonuses tied to shareholder returns). When you have only a dollar of your own at risk in $40 worth of investment, even a small profit margin is magnified greatly, especially when your risk is covered by bailout protection from the taxpayers. You can’t lose. This is wrong. Let the banks come up with their own money and assume their own risks, just like other market players have to do in the ordinary course of business. Why should taxpayers guarantee the profits of banks or any other organizations in a capitalist economy of risk-reward? Where is our reward for our guaranties of theirs? We have the cart before the horse, so to speak.

Given the risk-reward situation (the banks put up a dollar but get the profit from forty dollars and the taxpayer will back them up if they make a bad deal), why should banks not take on risks they would not ordinarily take on if their own money were at stake and taxpayers didn’t guarantee bailouts? When you are gambling with someone else’s money, why not take on the risks of, for instance, high interest-paying junk bonds of Greece and Argentina? Why not, since you can’t lose and taxpayers will pick up the tab if the deal goes south or some country nationalizes its banks (as did Iceland as a result of the chaos in the derivatives market during the recent Bush Great Recession)?

Big banks and other big financial organizations therefore have strong incentives to increase leverage (they make more for less of their own exposure but at correspondingly greater exposure to loss for you and me). What to do? U.S. banking regulators have already moved to limit big bank borrowing to less than $20 for each dollar of shareholder capital at risk, and just recently have moved to reduce such borrowing limits even further for the big banks where the ratio exceeds the minimums set by international regulators. As expected and behind the scenes, big Wall Street banks are furiously lobbying regulators to roll back and weaken their rules. They like unregulated leverage ratios and taxpayer bailouts. How dare those socialist regulators try to save the world from depression and reduce the risk of bailout for us taxpayers! They’re interfering with “private enterprise” (albeit publically supported)!

Ms. Bair correctly thinks that in the long run better capitalized banks are in the best interests of shareholders, creditors and the public at large, and though tougher capital rules may impact returns on equity in the short-term, that (per numerous studies) in the long-term, thick cushions of capital protect investors against unforeseen risks and position the banks to continue lending during downturns and reduces the risk of default for creditors. The failure of big Wall Street banks to lend during and after Bush’s Great Recession (dried up credit markets) was one of the reasons the downturn and our slow return to pre-bailout times was prolonged. The big banks did not use their bailout funds for lending that would have helped us out of recession sooner; they instead used our money for their own purposes.

If Hillary is elected in 2016, I would recommend Republican Sheila Bair for Treasury Secretary. GERALD  E

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