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Government Taken in Dealings with Wall Street: Accident or Design?

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We’ve grumbled at points during the process of throwing various lifelines out to the financial sector, that media has tended to focus unduly on the TARP (no doubt encouraged by the powers that be who are eagerly pushing “the banks are fine” line) at the expense of the vast net of additional subsidies. The ones garnering least attention are the various backdoor measures, in which it is hard to tally what the real costs are.

The famed PPIP, which is largely stillborn, was an effort to disguise the level of support. No one would see how much above current market prices the trades under PPIP were (recall they HAD to be above market prices, otherwise there would be no reason for all the incentives to bidders; the banks could just unload the paper).

Another subsidy is the government (we count the Fed as the government these days; it’s acting as an arm of the Treasury) dealing with Wall Street on lousy terms. Wall Street’s gain is the taxpayers’ loss (Willem Buiter argue the Fed will ultimately need to be recapitalized rather than taking the inflationary step of printing to cover its losses). Remember all those quantitative easing purchases of MBS? Of course, we have to remember it’s not QE, the Fed likes to claims it’s something different, but let’s dispense with those niceties now. The Fed is apparently taking crappy prices on its big programs.

The question is whether the poor terms are by design (as in another subsidy) or ineptitude?

First from the Financial Times:

Wall Street banks are reaping outsized profits by trading with the Federal Reserve, raising questions about whether the central bank is driving hard enough bargains in its dealings with private sector counterparties, officials and industry executives say.

The Fed has emerged as one of Wall Street’s biggest customers during the financial crisis, buying massive amounts of securities to help stabilise the markets. In some cases, such as the market for mortgage-backed securities, the Fed buys more bonds than any other party.

However, the Fed is not a typical market player. In the interests of transparency, it often announces its intention to buy particular securities in advance. A former Fed official said this strategy enables banks to sell these securities to the Fed at an inflated price.

The resulting profits represent a relatively hidden form of support for banks, and Wall Street has geared up to take advantage. Barclays, for example, e-mails clients with news on the Fed’s balance sheet, detailing the share of the market in particular securities held by the Fed.

“You can make big money trading with the government,” said an executive at one leading investment management firm. “The government is a huge buyer and seller and Wall Street has all the pricing power.”

A former official of the US Treasury and the Fed said the situation had reached the point that “everyone games them. Their transparency hurts them. Everyone picks their pocket.”

The central bank’s approach to securities purchases was defended by William Dudley, president of the New York Fed, which is responsible for market operations. “We believe that opting for transparency is a greater good,” he said. “If we didn’t have transparency, we’d be criticised on other grounds.”

However, another official familiar with the matter said the central bank “has heard that dealers load up on securities to sell to the Fed. There is concern, but policy goals override other considerations.”

Barney Frank, chairman of the House financial services committee, said the potential profiteering may be part of the price for stabilising the financial system.

“You can’t rescue the credit system without benefiting some of the people in it.” Still, Mr Frank said Congress would be watching. “We don’t want the Fed to drive the hardest possible bargain, but we don’t want them to get ripped off.”….

Larry Fink, chief executive of money manager BlackRock, has described Wall Street’s trading profits as “luxurious”, reflecting the banks’ ability to take advantage of diminished competition.

“Bid-offer spreads have remained unusually wide, notwithstanding the normalisation of financial markets,” said Mohamed El-Erian, chief executive of fund manager Pimco in Newport Beach, California.

A separate but related sighting from Roger Ehrenberg, who makes a point that few commentators have stressed: the “paying the TARP back” meme, which is somehow treated as a sign of government success, is in fact an abject failure. The TARP support was badly underpriced. And he doesn’t mean the dickering over the warrants, either.

From Ehrenberg:

What we have is a return to business-as-usual. Except it’s worse than that. The US taxpayer has been systematically looted out of hundreds of billions of dollars, yet the press is focused on Andy Hall and his $100 million payday. Whether this is too much pay for Mr. Hall misses the big picture. Yes, the Wall Street pay model is messed up, and I recently provided an alternative approach. But how about the fact that Goldman Sachs is posting record earnings and will invariably be preparing to pay record bonuses, not nine months after the firm was in mortal danger? Whether anyone will admit it or not, without the AIG (read: Wall Street and European bank) bail-out and the FDIC issuance guarantees, neither Goldman nor any other bulge bracket firm lacking stable base of core deposits would be alive and breathing today.

Goldman is a great firm with a stellar culture, and in most circumstances it’s risk management and funding practices have been second to none. Except when the crisis hit. It stood with the rest of Wall Street as a firm with longer-dated, less liquid assets funded with extremely short-dated liabilities….In exchange for giving the firm life (TARP, FDIC guarantees, synthetic bail-out via AIG, etc.), the US Treasury (and the US taxpayer by extension) got some warrants on $10 billion of TARP capital injected into the firm. While JP Morgan Chase CEO Jamie Dimon prefers to poke a stick in the eye of the Treasury, seeking to negotiate down the payment to buy back the TARP warrants, Lloyd Blankfein smartly paid the full $1.1 billion requested. He looked like a hero for doing so, a true US patriot repaying the US Government in full for its lifeline, thanking the US taxpayer in the process. $1.1 billion… $1.1 billion…Hmm…something doesn’t seem right. You know why it doesn’t seem right? BECAUSE THE US TREASURY MIS-PRICED THE FREAKING OPTION.

There is not a Wall Street derivatives trader on the planet that would have done the US Government deal on an arms-length basis. Nothing remotely close. Goldman’s equity could have done a digital, dis-continuous move towards zero if it couldn’t finance its balance sheet overnight. Remember Bear Stearns? Lehman Brothers? These things happened. Goldman, though clearly a stronger institution, was facing a crisis of confidence that pervaded the market. Lenders weren’t discriminating back in November 2008. If you didn’t have term credit, you certainly weren’t getting any new lines or getting any rolls, either. So what is the cost of an option to insure a $1 trillion balance sheet and hundreds of billions in off-balance sheet liabilities teetering on the brink? Let’s just say that it is a tad north of $1.1 billion in premium. And the $10 billion TARP figure? It’s a joke. Take into account the AIG payments, the FDIC guarantees and the value of the markets knowing that the US Government won’t let you go down under any circumstances. $1.1 billion in option premium? How about 20x that, perhaps more. But no, this is not the way it went down….

Where we are left today, dear taxpayer, is a lot poorer. Unless you are a major shareholder and/or bonusable employee of Goldman Sachs. Brains, ingenuity and value creation should be rewarded in all fields, Wall Street included. But when value created is the direct result of the risks borne by others for your benefit, the sharing of benefits needs to be re-allocated. This has not and apparently will not be done, and we, dear taxpayer, are the worse for it. Further, such a crisis could have provided the opportunity and the impetus for a re-look at capital markets risks, getting CDS users to support a central credit derivatives exchange and revised capital rules to incentivize better gap management. The banks lobby like hell against these changes, because it cuts into their fees, notwithstanding the systemic benefits such changes could have on the global financial markets. Banks now lobbying with US taxpayer dollars against changes that could protect the US taxpayer from more harm in the future. Something is terribly wrong with this picture, yet all anyone wants to talk about are executives getting paid too much. It’s called missing the forest for the trees, and it is a fixture of both those trying to sell newspapers (get clicks) and run our Government, and it pisses me off.

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20 comments

  1. jbmoore

    Well said, though I think some of it is incestuous – government officials smoothing their way into a cushy Wall Street job (or back into a firm they left for government service) when they leave the Treasury or the Fed.

  2. Independent Accountant

    YS:
    Absolutely! It's not for nothing Henry Paulson was our Treasury Secretary.

  3. Anonymous

    I get tired of that idea that executive compensation and the bonuses is a trivial amount of money and a distraction. If not for those bonuses, those crooks would not have behaved the way they did. The reinstitution of the 90 percent marginal tax bracket, like we had under Eisenhower, would go a long way toward reducing the incentives for this type of rapacious behavior by Wall Street actors.

  4. Siggy

    I remember Ike and I remember confiscatory tax rates and paying them and I remember IRS audits every year. In those days we had a rule, pay the taxes and move on. We also followed a plan of deferring income to avoid the confiscatory rate. I agree that Mr Hall's $100 million potential 'bonus' is chump change relative to problem. As to did the government overpay and under price the options, indeed they did. What would have happened if the options had been fairly priced? Most probably you would have had a complete collapse of the financial system. Would that have been the end of the world, no! Now had there been a complete collapse, we might also have riots and other dire occurences. In most cases the deal would not have been done had the Government not under prices the emergency loans. In the case of Bear Stearns, Merrill, Lehman and most aggregiously AIG, each of the institutions was more than insolvent, they were bankrupt. While the Taxpayers will bear the heavy brunt of the bailouts, what they are being denied is their day in court. Selling contracts you cannot possibly honor is a fraud and there should prosecutions. Assuming levels of risk that a balance sheet cannot support should be recognized for the theft that it is. The body politic is enraged because while they often lack information and education to fully analyze the thefts, they sense that equity has been trampled and they are going to have to pay for the sins of ommission and commission done by a band of kleptocrats. I also agree that the $100 million while it is chump change in relative terms, it is still too much much to be paid for actions that contributed to the financial collapse at hand.

  5. "DoctoRx"

    Great article. The anger it engenders in the reader is lost on the public that can't wait for the S&P to cross 2000.

    To Siggy 10:32 AM: There were ways to prevent complete financial chaos and get a better deal for taxpayers.
    Think Buffett-Goldman!!! Think Bagehot and the doctrine that in times of crisis, the central bank should make credit broadly available but at a high rate.
    If matters like those were done, with real upside for taxpayers for saving the backsides of the crooks, the only riots would have been by the banksters.

  6. Ryan

    The reinstitution of the 90 percent marginal tax bracket, like we had under Eisenhower, would go a long way toward reducing the incentives for this type of rapacious behavior by Wall Street actors.

    No it wouldn't.

  7. fresno dan

    As FT has said before – regulatory capture. The Financial Collapse was caused by these firms…our our gubermint's first priority…is saving these financial firms.

  8. Demetrius

    I have suggested today, 3 August, that there has been The Invasion Of The Jelly Men, arising from a Congressional Briefing on The Hill in DC a few days ago. Briefly it means we are all the subjects of a new breed of rulers, who are beyond any control.

  9. DownSouth

    @Siggy said: "Most probably you would have had a complete collapse of the financial system. Would that have been the end of the world, no! Now had there been a complete collapse, we might also have riots and other dire occurences."

    Reinhold Niebuhr makes the argument in Moral Man & Immoral Society that social change cannot be achieved without some form of violence. Speaking of the experiences of Gandhi:

    Beginning with the idea that social injustice could be resisted by purely ehtical, rational and emotional forces (truth-force and soul-force in the narrower sense of the term), he came finally to realise the necessity of some type of physical coercion upon the foes of his people's freedom, as every political leader must. "In my humble opinion," he declared, "the ordinary methods of agitation by way of petitions, deputations, and the like is no longer a remedy for moving to repentance a government so hopelessly indifferent to the welfare of its charge as the Goverment of India has proved to be.

    Another notable quote is that by the early 19th-century British parliamentarian Sydney Smith:

    From what motive but fear, I should like to know, have all the improvements in our constitution proceeded? If I say, Give this people what they ask because it is just, do you think I should get ten people to listen to me? The only way to make the mass of mankind see the beauty of justice is by showing them in pretty plain terms the consequences of injustice.

    Niebuhr insisted that the non-violence advocated and practiced by Gandhi (and later emulated by Martin Luther King) was not nearly so benign as they asserted, that it did indeed "coerce and destroy":

    Non-violent conflict and coercion may also result in the destruction of life or property and they usually do. The difference is that destruction is not the intended but the inevitable consequence of non-violent coercion. The chief difference between violence and non-violence is not in the degree of destruction which they cause, though the difference is usually considerable, but in the aggressive character of the one and the negative character of the other. Non-violence is essentially non-cooperation. It expresses itself in the refusal to participate in the ordinary processes of society. It may mean the refusal to pay taxes to the government (civil disobedience), or to trade with the social group which is to be coerced (boycott) or to render customary service (strike).

  10. Anonymous

    "The reinstitution of the 90 percent marginal tax bracket, like we had under Eisenhower, would go a long way toward reducing the incentives for this type of rapacious behavior by Wall Street actors."

    No, it would simply drive rapacious profiteers to favorable tax jurisdictions overseas.
    Increasing the marginal tax rate would however crush smaller entrepreneurs who must be here.

  11. Anonymous

    It's the end of a cycle with its foundational endings comes turmoil and change. For the better or just a repeat?

    No way GS or any other bank like structure survives even with continued propping up by the taxpayers. The debt won't allow it.

    With an ending cycle comes a lack of confidence, this time around, on a worldwide scale.

    Time line is less than 10 months for a complete reset.

  12. attempter

    DownSouth, that's excellent. There are many levels of action.

    Anon 1:29

    No, it would simply drive rapacious profiteers to favorable tax jurisdictions overseas.

    I'd happily let them go (of course taking only the clothes on their backs), and declare them stateless outlaws as they went. We'd see how "profitable" they were and how many friends they had once stripped of all protection and benevolence of US power.

    Increasing the marginal tax rate would however crush smaller entrepreneurs who must be here.

    I think that's a contradiction in terms. How can high marginal rates harm truly small businessmen?

  13. Anonymous

    I am ready for the evoluton we have all been waiting for. Bring on Change we can believe in or we will all get angrier and then do something or just continue to write white noise like this.

    Thanks for the posting Yves and for your anger.

    psychohistorian

  14. Hugh

    You know August 9 is coming up. This is the anniversary of the 2007 BNP Paribas freezing payouts from 3 of its funds heavily involved in subprimes. This led to a panic which marks the official bursting of the bubble. I wonder if there are any ideas or efforts to recognize this day.

    This article emphasizes how the American public have basically been looted by those who created the housing bubble and financial meltdown in the first place. The executives who caused this, who engaged in massive and systemic fraud are being rewarded with bonuses rather than contemplating their past activities from a jail cell.

    Two years on, we see a system completely unreformed, returning to its old ways and habits fueled by government giveaways. We also see that none of the underlying problems: the housing market, leverage, securitization, moral hazard, TBTF, exotic instruments, regulatory and political capture, debt and credit, fraud, and transparency and real accounting have even been touched.

    We have a system that is even more concentrated, where the books are more cooked, and where government and consumers are being ripped off to the tune of trillions by the most corrupt, least productive, and most wealth destroying sector of the economy. We are hearing a lot about an end to the recession, greenshoots, and recovery, but does anyone seriously think this can happen under these conditions?

  15. craazyman

    Puh-Leeze!

    As they say in Ronkonkoma.

    The US Marginal Tax Rate was about 80%+ from 1936 to 1963.

    http://www.truthandpolitics.org/top-rates.php

    Did that stifle innovation and entrepreneurship? I mean Really Now.

    If I were a Wall Street Bankster I'd do up a quick correlation and have the Treasury Secretary institute a 110% marginal tax rate, just to finance the innovation it would create — which, I would argue, would clearly benefit the rest of the nation to an extent far more than the taxes they'd be paying (if I could find a way to make money off the plan, that is).

    It would be great ROI for all Americans. I'd be on CNBC pitching it! I'd be on the Sunday talk show speaking in my quietly confident gravelly gravitas tone of voice. I'd be quote widely (and dumbly) by those enthralled with my brilliance.

    I might even be a Professor someplace between my consulting gigs.

    I'd be, I'd be, I'd be a miracle man, an avatar of innovation and inspiration. Not a nag full of condemnation! I'd raise a nation up to see it's own elevation. My very face would be a celebration — of the power of perusasion.

    I'd be a-"maze"-ing. :)

  16. Dave Raithel

    Re Ryan: Got an argument? Out here in the State of Misery, in Flyover Country, there's lately been a concerted effort by various numbnutts to eliminate the burdensome 6% income tax and just go with the Unfair Tax. Facts don't matter of course – people like me can cite and identify high tax states and nations with standards of living superior to Misery's; and then we can cite how poor life is in places like Texas (in which, I still argue, is the Asshole of the Universe) what got no income taxes, but like I said, facts, reasons, premises, data, arguments, don't matter. Q.E.D.

    Comrade Raithel
    Harpo Marxist Brigade

  17. Anonymous

    Introduce several new Bills into Congress:
    * Corporations/companies must have Life Spans not greater than 100 yrs. before they must DIVEST: The longer you live, the higher your TAX bracket.
    * Lobbyists can only belong to non-profit organizations not connected to any Corp/Company interest.
    * Any Corporation/Co reporting quarterly looses cannot give bonuses or a salary to any Director & above levels before lower level employees get paid, and/or redundant employees get a minimum 3-month salary/health coverage package.
    * Restrict Corporate Officer's from leaving their Company for Government or a Federal Reserve Jobs for 2 yrs. All must do 365 days of Local community volunteer work to be able to relate to those with less.
    * Skin the back of any white collar grand theft officer and use that skin for the chair that the next person in that position sits in. (ok, ok, Restrict getting a lawyer to pick their prison of comfort.)
    * Staff the SEC with 500 highly technical forensic investigators in ACCOUNTING …following the money; with the power to superceed National Security. The top 30 positions CAN NOT be politically appointed. Investigate, make backups on a bi-weekly basis and prosecute to the fullest extent of the law.
    * Audit The FED.
    * Set Campaign limits for City Mayor, Governor, Congressman, Senator, President to be paid only via TAXES.
    * Allow ALL participants to participate in an open debate to be AIRED 4-6 times throughout the Presidential campaign year, along with a 100 questionnaire comparison to be available via Library of Congress.

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