issue: Financial Services

Too Big to Run

Posted on by The Progressive Policy Institute

In discussions about the dismal state of the economy, the existence of “too big to fail” institutions has emerged as a recurring cause for concern. In particular, Bank of America and Citigroup (the first and third largest banks in the country, respectively) are firms whose size makes them an “existential threat” to the well-being of the economy.

(Bank #2 in size is JPMorgan, whose chief, Jamie Dimon, has been going around saying that we can end “too big to fail” without capping the size of financial institutions by providing regulators with resolution authority over banks — the ability to wind them down in an orderly fashion. While resolution authority can help in cases — like Lehman’s — where banks become insolvent, these after-the-fact measures would not prevent the liquidity crisis that selling against a too-big-to-fail institution would cause.)

While Citigroup has made efforts to break itself up, including selling off its half of the Smith Barney joint venture with Morgan Stanley, Bank of America under Ken Lewis has been resistant to downsizing, adamant that clients benefit from its size. But with the embattled Lewis having announced he will step down at the end of the year, the bank is looking for a new chief.

And that search has run up against a problem — not only are these firms seen as “too big to fail,” they’re also too big to run:

At least two candidates for the top job at Bank of America Corp. told directors that the giant bank should consider breaking itself up… [One candidate, former Bank of Hawaii CEO Michael O’Neill] recently told the Bank of America search committee that the bank’s risk-adjusted capital wasn’t being used productively. He added that the company should become simpler and less prone to volatility

How big is Bank of America? With over $2.25 trillion in assets, it has a pervasive presence in our economy. The numbers from the Wall Street Journal are staggering:

Bank of America is the largest U.S. bank by assets and has 6,000 branches, 18,000 automated-teller machines and relationships with 53 million households, or roughly one out of every two households in the U.S.

Whereas the mantra “bigger is better” was applied to the financial industry over the past 20 years, there is now a reassessment of that idea. But instead of providing clear guidance on how to get financial institutions to a more reasonable size (and, indeed, what that size is), the government is sending unclear signals, with conflicting announcements on which companies it is willing to bail out and tepid additional reporting requirements that won’t rein in outsized firms.

Rather than add to the uncertainty, the administration should come out with guidelines on how it proposes to solve the “too big to fail” problem. Whether through voluntary break-up of banks it has a stake in, anti-trust measures, or by instituting a too-big-to-fail tax, the administration should lay out clear rules for banks to follow. This will allow big banks to stop chasing their tails on executive decisions — like Bank of America is doing — and get back to business.

A Different Take on the Financial Transaction Tax

Posted on by The Progressive Policy Institute

Having just joined the Progressive Policy Institute from a stint on Wall Street, I’d like to offer a different perspective on the financial transactions tax (FTT).

Last week, Lee Drutman argued in favor of an FTT, saying that a transaction tax modeled after the one our British friends have would raise much-needed funds. Writing in light of the past year’s economic crisis, Drutman also said that an FTT would “throw a little sand in the gears of the giant financial speculation casino.” While both raising revenue and reining in Wall Street are goals worth pursuing, I would argue that the FTT is a second-best solution.

According to Dean Baker of the Center for Economic and Policy Research, a proponent of the FTT, a Yankee equivalent of John Bull’s 0.25% transaction tax wouldn’t raise $100 billion — it would raise less than a third of that. You need to crank up the tax — to double the proposed amount on stocks and higher on other products — to get close to a hoped-for $100 billion in revenue.

Also, it’s worth pointing out that a transaction tax didn’t spare the British from any of last year’s financial crisis — they had housing crises, government bailouts, and bank nationalizations comparable to what we saw on this side of the Atlantic.

A transaction tax is simply too blunt an instrument. Pouring sand in the gears is not a way to slow a machine down — it’s a way to try to bring the machine to a halt. Trying to second-guess trader activity by taxing stocks and other securities at differing levels to generate sufficient revenue will only drive broker dealers to encourage trading in high-margin products to make up for the dead-weight loss of the tax. This would drive traders away from liquid products to illiquid ones, increasing systemic risk. This increased focus on complex structured products drains liquidity from the system, as we saw last fall.

A better solution is one along the lines in Sen. Chris Dodd’s (D-CT) proposed financial reform bill. In addition to heightened capital and leverage requirements for systemically significant, “too big to fail” banks, higher capital requirements and stricter leverage controls could be imposed on trading in complex financial instruments. This would drive Wall Street firms looking to goose returns through leverage from trading the complex products that contributed to last year’s crisis to more liquid — less systemically threatening — products.

Investors that would want to speculate on complex derivatives could still do so, providing they did it with their own money. And banks that wanted to sell those products could still do so, provided they had adequate capital to backstop those activities. Letting these properly priced incentives work their magic would allow the market to behave in a responsible manner. Revenue could then be generated from that market activity by taxing gains made by speculators at a rate in line with income tax rates.

This would achieve the goals the FTT sets out to do — rein in derivatives risk and raise revenues — in a way that leaves market forces free to be a driver of renewed growth in our economy. But I suspect the supporters of the FTT will want to have their say, and I look forward to hearing it.

The Real Reason to Support a Financial Transaction Tax

Posted on by The Progressive Policy Institute

Thanks to Gordon Brown’s support, the idea of a financial transaction tax has been gaining a bit of attention over the last couple of weeks. The idea is simple: place a small tax (say, 0.25 percent or less) on all financial transactions.

Partially, it’s a way to raise a little revenue from those who can most afford to pay to create an insurance fund against future bailouts, which is how it is being billed. And just yesterday, it was reported that House Democrats have discussed using it to fund a jobs bill. (Dean Baker has estimated that the tax could bring in $100 billion.)

But mostly, it’s a good idea because it throws a little sand in the gears of the giant financial speculation casino.

Wall Street banks make a good deal of money by running very sophisticated computer programs, looking for tiny (and supposedly risk-free) arbitraging opportunities, and then making those opportunities pay off by investing with incredibly high volume. These trades are something like the equivalent of buying a bunch of dollars for 99.75 cents each. It’s a great deal if you can do it en masse, and an even better deal if you can also borrow almost all of the money you are investing.

But if banks had to pay a 0.25 percent tax on every dollar they sold, then it suddenly wouldn’t seem like such a good deal to buy dollars for 99.75 cents each. This is what a transaction tax would do.

This would mean that Wall Street banks would spend less time looking for short-term opportunities to buy dollar bills for 99.75 cents. This a good thing, because it’s hard to see how having some of the smartest people and most sophisticated computer programs dedicated to this kind activity helps the economy. Something is wrong when 40 percent of all U.S. corporate profits are coming from the financial sector, as they were for much of the 2000s.

A transaction tax would mean that banks would instead devote more time to investing their capital in good, long-term investments. This seems to me what a banking sector is supposed to do — allocate capital to the most promising business ventures, which then sometimes actually spur innovation and improve the standard of living for everyone, not just those who happen to be clever enough to take part in the big casino.

Unfortunately, Treasury Secretary Tim Geithner is against such a tax, and his support is pretty important, since any transaction tax would require an international agreement. This is not surprising, since Geithner is and always will be a creature of Wall Street.

Still, it’s hard not to marvel at the latest round of bonuses on Wall Street and wonder how it is that these guys are making $30 billion while the economy continues to stumble. Slowing down the Wall Street speculation machine might help channel some energy elsewhere — maybe into actual productive recovery.

Stuck in Dubai with the Kabul Blues

Posted on by The Progressive Policy Institute

I hope that’s the last time I get stuck in Dubai.

This past Sunday, I boarded a plane with ten other election monitors from Democracy International (including my PPI colleague Mike Signer) to head to Kabul and serve as monitors for the second round of Afghanistan’s presidential elections.

We never made it.

Before boarding the flight, we knew that Abdullah Abdullah — incumbent President Hamid Karzai’s main challenger — planned to boycott the election. We were under the impression that Abdullah’s boycott was unofficial, meaning that his name would still be on the ballot and that the election would proceed as a formality. But there was still reason to go — any election should be monitored for fraud, even when there’s only one active candidate.

Somewhere over Eastern Europe, however, we learned that Karzai had been declared the victor. Rather than risk further violence, expense, and logistical complications en route to a pre-determined outcome, the election’s cancellation was understandable, if disappointing.

However, that still left us several hours from Dubai, our transfer city. After being offered the unappetizing possibility of immediately jumping on a return flight to DC, our weary team came to grips with the situation.

“So what’s Dubai like?” I asked the group, not knowing much about my surroundings and anticipating that I had stumbled upon a short vacation in the Middle East. I forget who said it but, “It’s like Vegas but without the gambling and booze,” stuck out. And so it was.

Dubai is a city of contradictions piled on top of one another. It has glitz and glamour: towering skyscrapers, the world’s only seven-star hotel, an indoor ski slope, and a brand new metro system. Oil money, right? Nope. Dubai isn’t actually rich — petro-dollars only flow to Dubai’s “big brother” in the south, Abu Dhabi. Dubai adheres to a more Costner-ian vision: build it and they will come. And build it the sheiks did, all with highly leveraged debt.  The Emirate’s business plan is predicated on the success of the companies that invest in Dubai.

And this house of cards is starting to crumble as world’s financial sand shifts beneath its feet: real estate prices are dropping fast as international firms search for efficient investments.

The statistic that is most striking is tourism, down 60 percent this year. Why would it affect Dubai so harshly when other areas, though suffering, are muddling through? As far as I can tell, it’s because Dubai lacks an intellectual or cultural soul. In the race to construct the world’s largest X, they forgot to construct anything actually worthwhile, like a university, a museum, or cultural center. The sheiks seem to have recognized the deficit, but haven’t come up with an original idea — the planned museum is apparently a copy of the Louvre in Paris, and the new opera house mimics Sydney’s.

After two days, I understood why tourists had abandoned Dubai — I could spend a month marveling at Paris’ diverse cultural tapestry, but couldn’t muster a third day just to stick around for the indoor roller coaster at the Dubai Mall (the largest in the world, if you’re keeping score).

I was surprised to learn on my second morning that I had apparently observed an election during my diverted trip.  I opened my courtesy copy of Gulf News to find that Sheikh Khalifa Bin Zayed had been re-elected to a five-year term as president of the UAE. Mind you, I didn’t see any campaign posters about, but that may be due to the rather limited electorate: turns out you have to be a ruler of one of UAE’s seven Emirates to have a vote.

If he had one, I imagine Sheikh Khalifa’s platform on domestic issues would have raised some eyebrows. For example, despite legal adherence to a strict Islamic code, it’s easy to buy alcohol provided the establishment is foreign-owned (which is 85 percent of the city) and you’re willing to pay the 50-percent sin tax. But if you want to buy, say, a bottle of wine for your home, you can’t do that at any corner store; those places are a 45-minute drive into the desert and you need a personal alcohol license.  You can’t get one if you’re Muslim, of course, but no one checked my friend Mohammed for his as he sucked down a double vodka Redbull at the Calabar.

If you’re caught publicly intoxicated, then it’s curtains. I heard the story of a French girl who was rear-ended as she drove home a 9:00 a.m. on a Saturday morning after a night of carousing. Despite the fact that she was the victim, the police breathalyzed her and found her blood alcohol content to be a miniscule 0.009 BAC – but still in excess of the strict zero-tolerance law. Her punishment was six months in jail, followed by deportation.

But that’s Dubai — you can get away with anything unless you’re unlucky enough to be caught. It meshes nicely with Dubai’s motto: “What’s good for business is good for Dubai.” True enough.

The Best Hour You’ll Ever Spend on Insurance

Posted on by The Progressive Policy Institute

 

 

The radio show This American Life is a staple in every progressive’s listening schedule, and I’m no different. While occasionally there’s a show that I end up fast-forwarding through, more often than not it’s better to just pop some popcorn and listen.

This past week’s episode was the second of a two-part series the show put together on the insurance industry — apropos as Congress and the administration look at the chronic problems of health insurance in this country. The first part was informative, but not riveting. This second part, however, taught me that:

  • Insurance companies have a billing code for injuries from spacecraft
  • 20-25% of all doctor’s bills are spent on taking care of billing issues with insurance companies
  • Co-pay coupons for pills make them more expensive
  • There’s pet health insurance and hedgehog cancer
  • And the solution to our insurance woes could lie in…Maryland

One of the drivers of insurance cost growth is the fact that rates for procedures are negotiated between insurers and hospitals. That cost can see some big variance depending on who has the upper hand. A procedure can be 10 times more expensive in an area where a hospital is dominant than in another area where the insurance carrier is dominant. That’s where Maryland’s approach comes in: the state has a Maryland Insurance Administration that sets statewide rates for procedures.

But the bottom line of the episode is summed up in the anecdote of how — by ruling that companies can take a tax deduction for providing healthcare — an unknown bureaucrat in the 1950s IRS gave us the health care system we have today. No matter the outcome of negotiations on the Hill as they overhaul the industry, it’s these incentives that will drive how our health care industry will work.

The Right Way to Curb Executive Pay

Posted on by The Progressive Policy Institute

Yesterday, word was leaked that after telling Bank of America head honcho Ken Lewis to expect a goose-egg in salary for 2009, the Obama administration pay czar Ken Feinberg was going to give pay cuts to chief executives at four other financial firms, including Citigroup and AIG, and the automakers GM and Chrysler. While no one to the left of Steve Forbes can really defend multimillion dollar payouts to executives for driving companies and the economy into the ground (and don’t be fooled — despite getting $0 in salary, Lewis will take home $53 million in “other compensation” this year), this plan isn’t the way to rein in payouts. It might feel good in the short term, but it doesn’t solve anything and could cause problems in the future.

First, cutting pay for financial executives in 2009 is a bit like slamming the barn door after the horse has bolted. These problems were festering for many years, and most of the chief executives who are running these companies weren’t in charge when errors were made — the beleaguered Lewis excepted, and he’s stepping down at the end of the year. So they’re getting blamed for their predecessors’ decisions.

It also doesn’t affect the main culprits who got us into this mess. The notorious Joe Cassano from AIG FP in London — who almost single-handedly drove the insurer into the ground — is untouched by the decision.

And, despite what the administration might hope, the rest of Wall Street is not going to rein in salary practices either in sympathy with their comrades or fear of rebuke. The companies affected are the ones that still have significant stakes owned by the government. Those that have returned their TARP money — Goldman and JP Morgan — are unaffected.

Given the incentive to work for a company with pay limited by the government or one where pay isn’t limited, people will jump ship for the latter. This has the potential to make the already weak companies — Bank of America and Citi, for example — even weaker. Which means that we might have a bigger problem on our hands if either of the two largest banks in the country drift with no one at the wheel (Lewis’ decision to resign without a replacement means we might see this at Bank of America anyway).

Finally, there is the concern that this will be the only chance we have to move on keeping salaries in the financial industry in line with a level that benefits the country, not bankers. When taking a hard look at pay in the future, bankers can use this as political cover, claiming that the administration has already “dealt with the issue.”

A better solution to the pay issue is to look not at short-term, feel-good measures, but to implement longer-term solutions. Line up incentives for bankers with those of shareholders and the American people. Eliminate “guaranteed” bonuses. Replace cash payouts and options with restricted stock grants, vesting over time, keeping executives interested in the long-term health of companies.

Rep. Barney Frank (MA) has pushed the Corporate and Financial Institution Compensation Fairness Act of 2009 through the House with a “Say on Pay” measure, giving shareholders a non-binding say on management salaries at the annual meeting, an idea that has merit. But its non-binding nature and the fact that most shareholder votes are made by institutional investors (more often than not either current or former I-bank employees) as proxies for their clients limit the measure’s effectiveness. A more effective part of the same bill also requires bonuses to be in line with risk-taking.

Even better is the fact that incentives will be disclosed. A little known secret on Wall Street is that traders can make more than the CEOs, and the trader’s payouts are normally undisclosed. If such incentive structures were spelled out to investors, they might not be so sanguine in signing off.